Let’s begin by explaining what it means to incorporate a business. Quite simply, you file a form, commonly called Articles of Incorporation, with the Secretary of State. This is the essential step for creating a new and separate legal entity for running your business. There will be additional formation documents to be completed and your corporation will need to obtain its own federal tax identification number, or EIN, for use in opening a bank account, filing corporation tax returns, and other purposes.
This is a relatively simple process but is often intimidating for someone who has never been in business or has achieved a comfort level as a sole proprietor and is apprehensive about commiting to a different business structure that is unknown. We often talk to people in this situation. They are typically referred by their accountant who has advised them on many occasions to incorporate. The fact that you’re reading this article makes it likely you’re uncertain about taking the next step.
You presume that there are good and valid reasons for many businesses to incorporate, but is it really advantageous for a small business like yours with just one or two people involved? Here are the advantages to consider:
- No personal liability for business debts
- Easy to attract investors
- Tax advantage for saving on self-employment taxes
- Tax advantage with certain employee fringe benefits
- Transferability and liquidity considerations, and business continuity
Let’s look at each of these in more detail.
Personal Liability Protection
The owners (called shareholders) of a corporation have no personal liability for the debts and obligations of the business. If the corporation is sued, the money or property the shareholders have invested in the corporation is at risk, but not the personal assets of the shareholders.
Limitations on Protection of Personal Assets
In rare circumstances, creditors may be permitted to go after the personal assets of the shareholders. These typically involve situations in which the shareholders have failed to properly form the corporation and have disregarded all other corporate formalities such as issuing stock, capitalizing the corporation, opening a separate bank account, keeping any minutes, etc. Personal liability, also known as “alter ego liability”, may also be imposed on shareholders by a court where the shareholders have use the corporation to commit fraud or other circumstances would make it unjust to allow the shareholders to avoid personal liability.
Important Practices to Maintain Personal Liability Protection
In a small business corporation with just one or two shareholders, it may be easy for customers or vendors to think of the corporation and the shareholders as one in the same. This makes it especially important to follow a few simple rules to acknowledge the separateness of the corporation and its shareholders:
- Always sign documents, especially agreements, in the name of the corporation and not your individual name. This is known as signing in a representative capacity. Example: “Global Enterprises, Inc., by Ellen Johnson, President.”
- Keep business income and expenses completely separate from personal income and expenses. Don’t write a check from your business account to pay for your groceries or vacation expenses. Ideally, get a separate business credit card and use it only for business-related expenses.
- Make sure your corporation is properly formed and maintained. Get a corporate kit (minute book, stock certificates, and corporate seal) and prepare bylaws, organizational minutes, and issue stock to the initial shareholders. File annual reports and pay franchise taxes as required by your state to keep your corporation in good standing, and prepare written minutes as necessary to record important corporate activities.
Situations Where Loss of Personal Liability Protection is Unavoidable
Even when a corporation is properly formed and maintained and the separateness of the corporation is respected by its owners, there are common situations where the personal liability of the shareholders in a small business corporation will nonetheless be at risk. Many vendors, creditors and other third parties will often require personal guaranties from corporate officers, directors and shareholders for certain types of transactions. These include written leases (office, warehouse, equipment, and vehicles), bank loans and other type of financing transactions.
A corporation makes it easier to attract investors for your business because of the personal liability protection. An LLC offers the same personal liability protection as a corporation, but is not as investor-friendly for several reasons.
A corporation has a well-established, standardized, hierarchical control structure consisting of shareholders, directors, and officers. The shareholders elect a Board of Directors; the board in turn appoints officers who are responsible for the day-to-day operations. This separation of responsibility may play out in a larger company where the officers and the directors did not include the same individuals. The officers, rather than the board, may be responsible for decisions on hiring, firing, and compensating employees, while the board remains ultimately responsible for managing the company. Many investors recognize this specialization of roles as desirable.
Though the hierarchical structure is identical for a small business corporation, the practical reality is that most often a very small group of individuals serve in all three capacities. Nonetheless, the function of the parties in these capacities is still regulated by nearly 100 pages of corporation statutes. Even within this well-defined structure, however, there is considerable flexibility allowing particular groups of investors to be given special rights in the election of directors, the approval of specific board decisions, a preferential return on their investments, or other issues that may be of particular importance to investors.
In contrast, governance of a limited liability company starts with a very flexible management structure and very little statutory regulation. LLC statutes typically contain general rules that will apply only in the absence of a written operating agreement among the owners, called members. A well-prepared operating agreement may require extended and extensive negotiations and laborious drafting and revisions by an attorney. As circumstances change, amendments to the operating agreement are required. These factors are inherent in the LLC making it less attractive to most investors.
While it may be quibbling over semantics, many articles inaccurately refer to two “types” of corporations: C corporations and S corporations. These are, in fact, alternative tax classifications that any for-profit corporation may select. Regardless of which tax classification a corporation chooses, the corporation structure, the personal liability protection of the shareholders, and all other legal aspects of the corporate form are not in any way altered or diminished.
C Corporation Tax Advantages
Each tax classification has its own particular tax advantages. The advantage of a C corporation is the ability to deduct from its taxable income the expenses for certain employee fringe benefits while not having the value of such benifits be taxed as income to the receiving employee. These fringe benefits include contributions to employee retirement plans, adoption of medical plans allowing for payment of health insurance premiums or reimbursement to employees for payment of medical deductibles, and payments for limited amounts toward life insurance and disability insurance premiums.
S Corporation Tax Advantages
The tax advantages for fringe benefits are generally not available to shareholder-employees in an S corporation. However, two other tax advantages do apply. First, a C corporation has the potential of double taxation of corporate profits. A C corporation pays income tax on its profits as an entity. Profits that are then paid to shareholders as a dividend are also subject to tax at the individual level, and are not deductible expenses by the corporation.
In contrast, an S corporation is not taxed at the corporate level. It is known as a “pass-through” tax entity where profits and losses flow through the corporation to the shareholders on a proportionate basis according to their ownership interests, and the shareholders pay tax at the individual level on their share of profits. The potential of double taxation is thereby eliminated with the S corporation.
Shareholder-employees in an S corporation also are able to achieve a savings on self-employment taxes (SE taxes), specifically Medicare and Social Security taxes that have a combined tax rate of 15.3%. While a shareholder-employee in a C corporation would generally have his or her full share of profits for the year be paid in the form of salary, thereby being subject to SE taxes on the entire amount, in an S corporation the same shareholder-employee could take a portion of his or her share of profits for the year in the form of a reasonable salary, and the balance could be paid as a profit distribution. Under the Internal Revenue Code, only the salary portion is considered “earned income” subject to SE taxes; the portion paid as a shareholder profit distribution is not, thereby allowing the shareholder-employee in an S corporation to avoid the payment of SE taxes on the profit distribution portion.
Transferability and Liquidity Considerations
A corporation has advantages over other business forms with respect to liquidity. Stock in a corporation is generally more marketable than ownership interests in other types of business entities. Potential buyers know they won’t be personally liable beyond the amount of their investment for past or future problems of the business. Also, the tax consequences of transferring corporate stock are much simpler and better understood than the tax consequences of transferring partnership or proprietorship interests that can be quite complex.
Finally, the bundle of rights represented by ownership of corporate stock is relatively standard and more easily understood compared to the rights of parties under a partnership agreement or LLC operating agreement where provisions are generally created and customized from scratch.
Having ownership interests represented in corporate stock also simplifies the process of transferring fractional interests in a business to a spouse and children when a shareholder dies. In contrast to a sole proprietorship where the death of the owner generally causes the business continuation to be uncertain, a corporation has a perpetual existence and does not terminate with the death of a shareolder.
Not all of the above factors will apply in every case in evaluating a decision to incorporate. The factors that do apply will often be given different weight, or have varying degrees of importance, to different people. For example, you may own or be starting a business that involves greater risks, such as a restaurant or building construction, and may find it advantageous (if not essential) to incorporate for the personal liability protection regardless of any significant tax advantages.
On the other hand, you may be a marketing consultant, graphic designer or operate another type of business with a very small risk potential and may find it advantageous to incorporate only if significant tax savings can be achieved.
Choosing a business entity is an important decision. You not only have a choice of different entity types, but also different tax classifications available within an entity type. It’s important to discuss your personal situation with an experience professional to ensure you make the appropriate selections for your particular business.