What Are Corporation Pros and Cons?

Weighing corporation pros and cons is important when you start a business; deciding whether to incorporate is a big choice. Both have their advantages and disadvantage. Creating a corporation might prevent you from personal liability, while not incorporating might protect you from double taxation. Because of the impact on your business and personal life, it's important to weigh the pros and cons of forming a corporation.

Why Are Weighing Corporation Pros and Cons Important?

Weighing the pros and cons of starting a corporation are important because you aren't required to form a corporation when you start your business. Other types of businesses include:

  • Sole Proprietorship
    • A single person runs this business. It is unincorporated. However, the business and the individual are taxed as one. To file taxes, you use a Standard Form 1040 and a Schedule C.
  • Partnership
  • Limited Liability Corporation (LLC)
    • A single person or group can run this business. It combines pass-through taxation with the limited liability of a corporation. However, it is not actually a corporation.

As with any business structure, each of these has its pros and cons. To decide which works for you, analyze your business needs and the nature of your business carefully.

Pros of Forming a Corporation

  • Protection from Legal Liability
    • Once you've filed for incorporation, you have a limited liability over the business' debts and activities. Legally, the corporation is separate from you. To maintain limited liability, you must follow a number of corporate formalities.
  • Attracting Investors
    • The ability to issue stock is a selling point when attracting investors.
  • Stock and Stock Options for Employees
    • Offering stock and stock options to employees allows you to attract top-notch talent.
  • Organization
    • Corporations have an established power structure from top to bottom. This includes directors, officers, and shareholders. Each group has a defined set of roles and responsibilities.
  • Shareholder Protection
    • Creditors cannot go after shareholders. This also gives shareholders less privacy in return for limited liability.
  • Right to Due Process and Equal Protection
    • According to the Constitution's Fifth and Fourteenth Amendments, corporations have the rights of due process and equal protection in any legal proceedings.
  • Freedom of Speech
    • Unless forbidden by state government, a corporation has the right to free speech, just as a citizen would.

Cons of Forming a Corporation

  • Tax Liability
    • A traditional corporation's profits are subject to double taxation, meaning the corporation is taxed on its earnings. Shareholders who earned profits as dividends or capital gains are also taxed. This is usually only found in large businesses. Small businesses can avoid this by choosing an "S" Corporation status.
  • Time and Cost
    • Document preparation and fees paid to your state's Secretary of State Office cost time and money.
  • More Complicated
    • Corporations are much harder to form and maintain than other entities. They must also publish annual reports and other data. This allows creditors to assess their creditworthiness.
  • Following Corporate Formalities
    • To make sure you are actually functioning as a corporation, the government requires you to follow formalities. This includes shareholder meetings, maintaining financial independence, board of directors' meetings, and records of corporate activities. These are extra costs that don't add real value to the company.
  • The California Corporation Tax
    • If you start a corporation of any kind in California, you must pay an annual fee of $800.
  • Two Tax Filings
    • You must file separate income and business taxes. You can't deduct business losses on your own tax return.
  • Heavy Regulation
    • Federal, state, and local entities impose heavy regulations on corporations. This can cost a lot of money and prevent profits and growth.
  • No Right to Legal Counsel
    • Because a corporation isn't an individual, it cannot receive a court-appointed attorney if it cannot afford one as outlined in the Sixth Amendment.
  • Self-Incrimination
    • A corporation has no protection against self-incrimination as described in the Fifth Amendment.

An S Corporation

There are two types of corporations you can set up: an S Corporation and a C Corporation. Both are valuable to the right person or entity. An S Corporation, or S Corp, issues stock and has the same pros and cons as any other corporation. However, its owners are the shareholders. This protects them from liability. If the business goes under, their personal assets are untouchable. An S Corp passes along income, losses, deductions, and credit to its shareholders. Around 97 percent of S Corps have three or fewer owners.

An S Corporation is also similar to a sole proprietorship. Each shareholder is exempt from double taxation and subject to their own tax rates.

An S Corporation's features include:

  • Tax Savings
    • Individual shareholders report their earnings on their personal income tax return. The S Corp isn't taxed on a federal level. This results in significant tax savings for the corporation. Shareholders also receive payments tax-free.
  • Combining the Benefits of an LLC
  • Separation of Business and Personal Assets
    • Unlike a sole proprietorship or partnership, an S Corp separates the assets of owners and the company.

To form an S Corp, the owners must meet some legal requirements:

  • Have only one class of stock.
  • Have fewer than 100 shareholders.
  • Be an eligible corporation. Financial institutions, sales corporations, and insurance companies cannot form an S Corp.
  • Incorporate in the United States.
  • Shareholders can only include trusts, estates, and individuals. Nonresident aliens, other corporations, and partnerships cannot be S Corp shareholders.

Pros of an S Corp

  • Credibility to investors, employees, clients, and customers.
  • Protection from liability.
  • Pass-through taxation that lets shareholders avoid double taxation. It's also beneficial during the early stages of a business when losses are higher.
  • Easy to transfer ownership via sale or merger.
  • Flexibility to file as a C Corp in the future.

Cons of an S Corp

  • Less flexibility when it comes to dividing up profit and loss.
  • Increased tax obligations that might catch the IRS's attention. You can lose S Corp status if you file your taxes incorrectly.
  • A lengthy formation process with more legal involvement.
  • Stock restrictions.

A C Corporation

A C Corporation, or C Corp, is an incorporated business that is taxed separately from its owners. How a C Corporation is formed depends on the state, but taxation is similar across the board. C Corps are appealing to many investors, business owners, or startups. Like other businesses, a C Corp only needs to have one owner but can have as many as possible.

A C Corporation's features include:

  • Perpetual Existence
    • Even if the owner dies, transfer of ownership is easy.
  • Limited Liability
    • Like an S Corp, a C Corp is a separate entity from the owners. If the business fails, creditors cannot take personal assets.
  • Easy to Raise Capital
    • Investors like C Corps because of stock options. This allows them to make more money over time.
  • Easy to Find Good Talent
    • Employees also like stock options, helping you attract and hire the best people.
  • No Restrictions on Ownership
    • Anyone of legal age (18) can start a C Corp without restriction.

To form a C Corp, owners must agree to hold annual shareholder meetings and take notes on them.

Pros of a C Corp

  • Can sell stock to raise capital.
  • Well-established structure with defined roles and responsibilities.
  • Employee stock options and stock benefits.
  • Ability to take legal action or sue.
  • The right to enter into contracts.
  • Creating a lower tax rate by splitting profits and losses between the business and the owners.
  • Opportunity to use a medical reimbursement plan. This allows the C Corp to write off medical costs.

Cons of a C Corp

  • Extensive paperwork
  • Need for professional legal or financial help, such as lawyers and accountants
  • More time-consuming than other entities
  • Lots of regulations mean less flexibility
  • Possibility of double taxation
  • Subject to lawsuits

How to Set Up a C Corporation

Once you decide to set up a C Corporation, you must.

  • Choose the state where you want to incorporate.
    • The state, not the federal government, creates all C Corporations. You can do this yourself or hire an attorney. Filing fees range from $50 to $500 depending on the state.
    • Filing in the state where you conduct business is usually best. It minimizes costs, fees, and taxes. However, incorporating in Delaware or Nevada might have advantages. No matter where you set up, you must file taxes in the state where you do business. Otherwise, you might be viewed as an illegal entity.
  • Choose between doing it on your own or getting help.
    • Choosing an online service to start your corporation can be smart. These websites usually file your articles of incorporation and get you an Employer Identification Number (EIN). Outside of those tasks, they aren't comprehensive.
    • Doing it on your own is difficult. If you don't follow through, you might not become incorporated.
    • Hiring an attorney or CPA will cost between $1,000 and $3,000. Their expertise is more than worth the cost.
  • Draft your articles of incorporation.
    • Articles of incorporation are essentially your business' birth certificate. Some states require multiple filings, so check to see what forms you need. Information in the articles of incorporation must include:
      • Name and business address. The name must describe the business without being confused with another company. You should also choose a name that translates into a web domain. The corporate name must be followed by Corp., LTD., or Inc.
      • Nature of your business.
      • Designation of a registered agent. This person can receive legal documents on the corporation's behalf.
      • Stock information. This includes the initial number of shares, classes of stock, and price per share.
      • Other. In some states, you must include the name(s) of the incorporator(s) and the directors.
  • Write the bylaws and shareholder agreement.
    • Bylaws are the corporation's rules and regulations. They cover any topic that might come up and can be amended in the future. States might have guidelines for these rules, but the corporation can often create its own rules. Bylaws should include:
      • Place and time of meetings for shareholders, officers, and directors.
      • Location of inspection for corporate records.
      • Rules for amending the bylaws.
      • Rules for approving transactions.
      • Number of directors and term lengths.
      • The year of incorporation.
      • Compensation of officers and directors.
    • Shareholder agreements should include:
      • Buyout agreements.
      • Possibilities in the event of bankruptcy, death, retirement, or disability.
  • Pay Taxes
    • A C Corp files IRS Form 1120 to report its income and expenses. The tax rate ranges from 15 percent to 35 percent at the federal level. Shareholders only pay tax when they get distributions from the corporation. Shareholder distributions include:
      • Salary and bonuses at their personal tax rate.
      • Dividends taxed at a maximum rate of 15 percent.
      • Fringe benefits, which are usually tax-free.
    • All states charge some sort of taxes. Usually, there is a minimum payment called a "franchise tax," even if there is no franchise.
  • Other Details
    • Get an EIN. This is free to do, and anyone in the corporation can do it.
    • Pay other taxes, including sales, payroll, usage, and cost of goods taxes.
    • Get licenses and permits. You might have a legal requirement to get these before starting your business.
    • Get insurance. Without insurance, you can't safeguard your business assets.

An Example of Corporation Advantages

Two investors start a company with $10,000 invested each. To build their product, they contract with a supplier for $10,000 a month for 12 months. The first half of the year goes great, but six months in, their only customer goes bankrupt. They still have six shipments of goods left at a total of $60,000. Instead of finding alternatives, they close the business. Despite still being contractually obligated, the supplier cannot touch their personal assets. Only the assets of the company are on the hook.

Pros of an LLC

  • Flexibility to be taxed as you choose. You can pay taxes as a sole proprietorship, partnership, S Corporation, or C Corporation.
  • Less paperwork than a corporation.
  • Fewer filing fees than a corporation.
  • Can form as a single person or with unlimited owners.
  • Protection from liability.
  • Owners can receive profits and write off forfeitures larger than their percentage interest in the LLC.

Cons of an LLC

  • Limited flexibility, as the ownership is spread across several members.
  • Harder to raise financial capital.
  • Franchise taxes and capital values taxes levied in some states.
  • Can't pay yourself a wage.
  • High renewal fees and publication requirements.

Pros of a Sole Proprietorship

  • Complete control of your day-to-day operations.
  • Flexibility.
  • No complicated legal agreements found in LLCs or corporations.
  • 100 percent of profits go in your pocket.
  • Easier to organize and form.
  • Lowest tax rates.

Cons of a Sole Proprietorship

  • Liable for all business debts.
  • Banks are less likely to issue loans.
  • Creditors can go after your personal property.
  • Harder to raise capital.
  • If the business owner dies, the business ends.

A Partnership

Partnerships are unincorporated businesses that come in three forms:

  • Limited
    • A limited partnership has limited partners that report to the general partner. They are less responsible for actions of the business and debt collections.
  • General Partnership
    • All owners are equally responsible for liability and debt, as well as profits.
  • Limited Liability
    • Limits personal liability for all partners.

Pros of a Limited Partnership

  • No liability.
  • Ability to make a profit.
  • Total liability goes to the general partner.
  • Flow-through income taxation for all partners.
  • Less expensive than incorporating or becoming an LLC
  • More attractive to some investors.

Cons of a Limited Partnership

  • No managerial power. This is the power of the general partner.
  • More paperwork and filings than a general partnership.
  • Limited partners can lose their limited liability if they decide to take on the roles of manager.

Pros of a General Partnership

  • No incorporation paperwork with the federal government.
  • Flow-through income taxation for all partners.
  • Each owner is equally responsible for debt and loss.
  • Less expensive than incorporating or filing.
  • Partners can pool resources and share financial obligations.
  • No strict corporate structure.

Cons of a General Partnership

  • Creditors can go after your personal property to satisfy a claim.
  • Liable for debts and actions of your partner.
  • Limited capacity to raise money and attract investors.

Pros of a Limited Liability Partnership

  • Flow-through income taxation for all partners.
  • Can choose the management structure.
  • Each partner can assume managerial roles.
  • Less expensive and less paperwork than an LLC filing.

Cons of a Limited Liability Partnership

  • Only available to specific businesses or occupations.
  • Partners are responsible for negligence, creditors, and proprietors.

Frequently Asked Questions About Corporations

  • What's the difference between an S Corp and a C Corp?

The main difference is how they're taxed. A C Corp taxes the business and owners separately, as described in Subchapter C of the Internal Revenue Code. In an S Corp, owners or shareholders are taxed based on the amount of shares they own as outlined in Subchapter S of the Internal Revenue Code.

Choosing whether to incorporate will affect your business' success or failure. Because so much depends on this choice, consulting a lawyer is a wise decision. Thankfully, the attorneys of UpCounsel have the experience, knowledge, and understanding to get the job done right and give excellent advice. Post your legal need if you need help choosing which business entity is best for you or whether to form an S Corp or a C Corp.