Key Takeaways

  • A corporation is a distinct legal entity that provides limited liability protection to its owners.
  • Key advantages of corporation status include access to capital, perpetual existence, credibility, and transferability of ownership.
  • Major disadvantages include double taxation, complex formation and compliance requirements, and reduced flexibility compared to other entities.
  • Management is handled by a board of directors, which can create challenges like agency conflicts between owners and managers.
  • Corporations may be structured as private or public, affecting fundraising and disclosure requirements.
  • Subtypes such as C corporations, S corporations, and nonprofit corporations each carry unique tax and operational implications.

The advantages and disadvantages of a corporation must be considered before you incorporate your business. Some of the biggest benefits of this business structure include access to funding, limited liability protections, and an unlimited lifespan. In terms of disadvantages, corporations are required to observe strict formalities and may be subject to expensive double taxation.

What Is a Corporation?

Before discussing the advantages and disadvantages of a corporation, we must first understand what makes up a corporation. The simple definition of a corporation is a legal business entity that exchanges ownership of a company, also known as stock, through shares.

Whether private or public, a corporation has investors and it must operate in the best interest of those investors at all times. Thus, a corporation is a group of people collectively serving as one legal entity and pursuing one goal: to generate the highest net return for its shareholders.

Advantages of Forming a Corporation

When it comes to deciding on a business entity, there are several benefits to choosing the corporation designation. One of the most important benefits to the corporation is that, in most cases, the owners are not personally liable for any debt or legal judgements associated with the corporation. In other words, if a company files bankruptcy and doesn't have enough assets to fulfill the obligation, the shareholders will not be personally liable.

Another advantage to the corporation designation is the ease of funding. Corporations can transfer ownership by buying or selling its shares. Public corporations have a much easier time than private companies to exchange shares, but regardless, corporations offer its members the easiest means for transferring ownership.

Unlike other businesses, a corporation has no limit to its life. If owners die or want to dissolve their shares, they simply sell or transfer their ownership to someone else. The only way a corporation ends is if it deliberately ended through liquidation or other means.

Another benefit to the corporation is the tax liability separation. A corporation's taxes are independent of your personal taxes. As an owner, you only pay taxes on the salary or dividends paid to you by the corporation. The corporation has separate corporate taxes which are taxed at a separate rate than your individual taxes.

Additional Advantages of a Corporation

Beyond limited liability and easier access to funding, there are several other advantages of corporation structures that business owners should consider:

  • Enhanced Credibility: Incorporating often makes a business appear more professional and trustworthy to lenders, investors, suppliers, and customers. This credibility can help attract contracts and favorable financing.
  • Unlimited Growth Potential: Because corporations can issue stock, they are not limited in the number of owners they can take on. This feature makes it easier to raise large sums of capital compared to sole proprietorships or partnerships.
  • Employee Incentives: Corporations can offer stock options, profit-sharing plans, and other equity-based benefits. This allows them to recruit and retain top talent more effectively.
  • Continuity of Existence: Unlike other business entities tied to the life of their owners, corporations exist perpetually. Ownership can change hands without affecting the entity’s operations or contracts.
  • Tax-Deductible Benefits: Certain employee benefits, like health insurance and retirement contributions, may be tax-deductible to the corporation, lowering its taxable income.

Disadvantages of Forming a Corporation

Forming a corporation does have disadvantages. If you want to form a corporation, it will require investing more money and time than if you went with another business entity. You will need to file the appropriate registration, fulfill capital requirements, and formally list your corporate directors among other things.

Additionally, there are legal requirements and annual documentation that must be submitted. Because there are many government agencies that monitor corporations, fulfilling the paperwork necessary to meet all requirements can be cumbersome.

Another disadvantage to corporations is the double taxation that happens when dividends are paid to shareholders. Corporate taxes must be paid on profit at the corporate-level and again at the individual level. This double taxation can be avoided if your corporation is able to file as an S corporation. The S corporation files a Form 2553 to the IRS which eliminates the double taxation that C corporations are forced to pay.

After forming your S corporation, you will be allowed to avoid double taxation by passing certain financial issues from your corporation to your shareholders:

  • Income
  • Deductions
  • Losses

Certain restrictions will be placed based on who can sit on your corporation's board of directors. For example, with a small corporation, two members of the same family are not allowed to serve as corporate directors at the same time.

Another tax disadvantage of corporations involves dividends. When a corporation pays dividends to its shareholders, the company is not allowed to deduct these payments from its income. Because corporations must pay a variety of taxes, and may earn different types of incomes, these companies typically must handle a tremendous volume of paperwork which would not be required with another business entity.

Incorporating your company can cost a great deal of money depending on the state where you plan for your business to operate. If you need help with the required incorporation paperwork, you may want to hire an attorney. While hiring an attorney is not a requirement for incorporation, having an experienced legal professional on your side can make the process much easier.

Depending on the state where you form your corporation, you may spend up to $150 on filing fees, assuming you are filing directly with your Secretary of State. In addition to these initial fees, you will need to pay ongoing fees to maintain your company's standing.

Corporations are required to file an annual report in many states, for example, and the fee for this report can be $150 or more. Forming a nonprofit corporation is even more difficult because of the increased paperwork. Aside from meeting state requirements, nonprofit corporations must obtain a tax exempt status from the IRS, and simply applying for this status costs $750. Some states require that nonprofit corporations apply for tax exempt status at both the state and the federal level. If your company is already dealing with a lack of funds, paying the various fees needed to form a nonprofit corporation can be very difficult, if not impossible.

The need for meticulous record keeping is another big disadvantage of the corporate structure. Unlike other business entities, corporations are required to keep a large number of records, and failing to maintain these records can put your company's corporate status at risk. Some of the records that corporations must keep include:

  • Annual reports
  • Tax returns
  • Business accounts that are distinct from personal accounts
  • Records of director and shareholders meetings
  • Business licenses

Corporations are required to file Articles of Incorporation in the state where they intend to do business. The drawback of this is that filing fees can vary from state to state, so forming your corporation in certain states may be more expensive than in others. Some states also require that corporations adopt and file bylaws. Writing these bylaws can be time consuming depending on the corporation, and may require assistance from an attorney. If you decide to form a nonprofit corporation, you may need to register your charity each year. As you might expect, this annual registration always requires paying a fee, adding to your organization's operating costs.

Some entrepreneurs interested in forming a corporation decide to file their own paperwork. Although this is certainly possible and can save you a great deal of money, you need to schedule at least one consultation with an experienced business attorney. During this consultation, your attorney can tell you about some of the potential pitfalls of forming a corporation and may give you a few tips that will make the process of incorporation much simpler.

Following strict rules is a huge disadvantage of corporations. In addition to appointing a board of directors and holding annual meetings, you will have to follow the correct rules for selling stock. If you're not careful about following these rules, your corporation may lose its good standing, which can result in serious financial and legal consequences.

If you are passionate about owning and operating your business, forming a corporation is usually a poor choice. Individuals cannot personally own a corporation, as these entities are separate from their owners. Also, a corporation is governed by a board of directors instead of an individual owner. While forming a corporation can be very beneficial, you won't have control of your company the way you would with a sole proprietorship.

You should also consider the fact that if you form a corporation, there's no guarantee that you will be able to maintain your standing in your business. The board of directors can take total control of your business, and you may find yourself forced out of the business that you founded.

Additional Disadvantages of a Corporation

While corporations offer significant benefits, they also come with additional drawbacks beyond those already discussed:

  • Cost of Formation and Maintenance: Incorporating typically involves higher filing fees, annual state fees, and the costs of drafting bylaws or corporate governance documents.
  • Ongoing Regulatory Scrutiny: Public corporations in particular must comply with Securities and Exchange Commission (SEC) requirements, including quarterly reporting and shareholder disclosures. These requirements can be expensive and time-consuming.
  • Rigid Formalities: Corporations are required to hold annual meetings, maintain minutes, and keep thorough records. Failure to do so risks losing liability protection.
  • Potential for Loss of Control: Founders may lose decision-making power as voting rights are distributed among shareholders and exercised through the board of directors.
  • Double Taxation in C Corporations: C corporations pay corporate income tax, and shareholders are taxed again when receiving dividends. While this can sometimes be offset by retained earnings or benefits, it is still a major disadvantage compared to pass-through entities.

Management Structure in a Corporation

An interesting note about corporations is that as ownership dilutes it can become difficult for owners to provide insight or direction. When there is no clear or definitive direction, the corporation's management team can make executive decisions, as long as they act with the best interest of the owners or shareholders in mind.

As ownership spreads out and shareholders increase, a board of directors is often chosen to make decisions for the entire corporation. The board of directors are also tasked with selecting the management team. One of the difficulties with running a corporation is the dissemination of power and the loss of accountability as control spreads. This lack of accountability can lead to what is known as the “agency problem” which is when management makes decisions based on their self-interest instead of the interest of shareholders.

Public vs Private Corporation

Corporations can choose to be privately-held or publicly traded. A private corporation has a centralized group of investors that have limited options for transferring or selling their shares. Because it is privately-held, a shareholder cannot sell their shares in an open marketplace to the general public.

The other option for corporations is to be a public company which means the shares of the corporation can be bought and sold to the general public. To become a public company, one must register their shares for sale with the Securities and Exchange Commission (SEC). When a company does go public, they will issue an IPO or initial public offering.

Types of Corporations

In addition to distinguishing between public and private corporations, it’s important to understand the main types of corporate structures:

  • C Corporations (C Corps): The default form of corporation, which offers unlimited growth potential and broad ownership possibilities. However, C corps are subject to double taxation and more stringent reporting requirements.
  • S Corporations (S Corps): These are corporations that elect special tax status with the IRS. They avoid double taxation by passing income and losses directly to shareholders, but they have ownership restrictions (limited to 100 shareholders who must be U.S. citizens or residents).
  • Nonprofit Corporations: Organized for charitable, educational, or public purposes, nonprofits can apply for tax-exempt status under Section 501(c)(3). They must adhere to strict operational rules to maintain this status.
  • Benefit Corporations (B Corps): Recognized in some states, B corps balance profit with social or environmental goals. They must report on their social impact in addition to financial performance.

Frequently Asked Questions

1. What are the main advantages of a corporation?

The primary advantages of corporation structures include limited liability for owners, easier access to capital, perpetual existence, and the ability to issue stock for growth.

2. What are the disadvantages of forming a corporation?

Disadvantages include double taxation for C corps, higher costs of formation and compliance, rigid formalities, and potential loss of direct control by founders.

3. What is the difference between a C corporation and an S corporation?

A C corporation pays taxes at the corporate level and shareholders are taxed again on dividends, while an S corporation avoids double taxation by passing income directly to shareholders.

4. Can a corporation exist without shareholders?

No. Corporations are defined by their shareholders, who are the owners of the company. However, a single person may incorporate and act as the sole shareholder in many states.

5. What type of corporation is best for small businesses?

Small businesses often choose S corporations to benefit from pass-through taxation and liability protection. However, the best choice depends on ownership structure, funding needs, and long-term goals.

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