Advantages and Disadvantages of a Corporation: Everything You Need to Know
The advantages and disadvantages of a corporation must be considered before you incorporate your business.6 min read
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.
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:
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.
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.
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