Key Takeaways:

  • Double Taxation: Corporations face taxation on both the corporate level and on dividends distributed to shareholders, increasing the tax burden.
  • Higher Formation and Maintenance Costs: Setting up a corporation is typically more costly than other structures, with ongoing fees for compliance and filings.
  • Strict Regulatory Requirements: Corporations must meet extensive regulatory standards, including annual meetings, detailed record-keeping, and regular filings.
  • Management Complexity: Shareholders generally do not control daily operations, with a board of directors overseeing decisions, which can lead to conflicts over business direction.
  • Reduced Flexibility: Corporations have less operational flexibility compared to LLCs or sole proprietorships, particularly regarding management and compliance.

Corporations: What Are They?

Before discussing the disadvantages of corporations, it may be helpful to know that a corporation is a business that is a legal entity of its own. It is separate from those who start it or are employed by it. Corporations provide liability protection for those who start them. Other business structures, such as a limited liability company (LLC), also provide this protection.

This means that you can protect your personal assets by filing as a corporation or an LLC. While a corporation makes it easier to raise money and transfer ownership, there are a few disadvantages you should consider.

Disadvantages of Corporations

There are many reasons you may choose to form something other than a corporation. These reasons fall into a few categories.

Taxes

  • Corporations are subject to double taxation. They are taxed on a corporate level, and shareholders who receive dividends are then taxed on a personal level.
  • You'll also have to pay self-employment taxes if you're an employee of the company.
  • Paid dividends cannot be deducted from taxable income.
  • Forming an S-Corp can prevent some of these tax issues, but not all corporations are eligible.

Documentation and Costs

  • Forming a corporation is more expensive and time-consuming than other business entities.
  • Corporations face government oversight and must keep detailed records of business activities.
  • Most states charge a yearly franchise tax fee.
  • Articles of incorporation, bylaws and other documentation must be completed before filing.

Management

  • You cannot own a corporation. This means a board of directors will be making the decisions.
  • The board of directors could potentially remove you from company.
  • The management team could ignore owner oversight if no one has a majority interest in the company.

Taxation and Financial Burden

One of the primary disadvantages of corporations is the financial burden associated with double taxation. Corporations are taxed at both the corporate and individual levels, meaning that profits are taxed when earned by the corporation and again when distributed as dividends to shareholders. Additionally, corporations cannot deduct dividends from their taxable income, which can increase the overall tax liability. Forming an S-Corporation can help alleviate some of these tax issues, but not all corporations qualify for this designation.

Regulatory Complexity and Compliance Requirements

Corporations face stringent regulatory requirements that mandate substantial record-keeping and compliance measures. They are required to file detailed articles of incorporation, create bylaws, and hold regular board meetings with documented minutes. Most states also impose annual report filings and franchise taxes, adding to the regulatory burden. Additionally, federal and state tax compliance can be complex, often necessitating professional legal and financial assistance to ensure adherence to various laws.

Formation and Operational Costs

Setting up a corporation is generally more costly than other business entities. Expenses include initial incorporation fees, state filing costs, and legal fees for drafting essential documents. Most states require corporations to pay franchise taxes or additional fees, which can increase operational costs over time. These fees may recur annually, contributing to the ongoing cost burden of maintaining a corporation. For smaller businesses, these expenses may make a corporation less attractive compared to other structures like LLCs.

Control and Decision-Making Limitations

In a corporation, decision-making authority lies with the board of directors, limiting individual shareholders’ influence on the company’s strategic direction. While shareholders own shares in the company, they do not directly manage daily operations or business policies, which can create challenges if the board’s priorities differ from those of certain shareholders or founders. Founders without a majority shareholding may also risk losing control over the company, as the board has the power to remove executives or shift business strategies.

Examples

  • If you file a corporation, your shareholders are going to be taxed after your corporation has been taxed. With an LLC or S-Corp, dividends distributed are only taxed on the personal level.
  • If you form a corporation and disagree with the board of directors over an issue, it could possibly vote to remove you. If you formed an LLC, you would need no board of directors. You could also choose to have as many or as few owners as you like.
  • By forming a corporation, you must have yearly meetings, take minutes at these meetings, and deal with many other regulatory hassles. If you form an LLC, there are fewer government requirements.

Loss of Flexibility Compared to Other Structures

Corporations are generally less flexible than LLCs or sole proprietorships, especially regarding operational changes and management structure. While LLCs can have flexible management structures, corporations are legally required to follow a formal hierarchy, including a board of directors and officer roles. Additionally, corporations must hold annual meetings, create and maintain bylaws, and adhere to more rigid compliance requirements than other business structures. These factors may reduce the adaptability of a corporation, making it challenging to pivot quickly or simplify operations.

Common Mistakes

  • Choosing any business structure without doing your homework. Seeking legal advice is recommended.
  • Failing to complete all necessary documents before filing.
  • Using downloadable, one-size-fits-all templates. State laws vary and can change. Online templates are often inaccurate.

Compliance Risks and Legal Obligations

Corporations must remain vigilant about compliance, as failure to meet legal obligations can result in fines, audits, and even lawsuits. Compliance requirements include timely filings, accurate financial reporting, and adherence to employment regulations, such as wage standards and anti-discrimination laws. Corporations are also subject to regular audits and investigations, which can be costly and disruptive if not managed properly. Consulting legal and financial experts can help corporations maintain compliance and mitigate potential risks.

Frequently Asked Questions

  • Would my business qualify for S-Corp status?

The IRS lists several S-Corp requirements that include having less than 100 shareholders and several other obligations.

  • What are the differences between an S-Corp and a traditional corporation (C-corp)?

The main difference is that S-Corp businesses don't face double taxation, but they do still have limits.

  • I heard incorporating in Delaware provides better benefits. Is this true?

There are many benefits to incorporating in Delaware, but there are drawbacks, too. You should speak with a legal expert to figure out the smartest move for your company.

  • How much does it cost to file for a corporation?

This price varies by state, and it can go well over $400 in some areas. You can review online lists of corporate filing fees by state.

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