Before forming a corporation, a business owner or prospective business owner should become familiar with the advantages and disadvantages of incorporating.
Advantages of Incorporating
The following are some of the advantages that a corporation has over other forms of businesses, such as sole proprietorships and partnerships.
The main reason for forming a corporation is to limit the liability of the owners. In a sole proprietorship or partnership, the owners are personally liable for the debts and liabilities of the business, and in many instances, creditors can go after their personal assets to collect business debts. If a corporation is formed and operated properly, the owners can be protected from all such liability.
Example: If several people are in partnership and one of them makes many extravagant purchases in the name of the partnership, the other partners may be held liable for the full amount of all such purchases. The creditors may be able to take the bank accounts, cars, real estate, and other property of any partner to pay the debts of the partnership. If only one partner has money, he or she may have to pay all of the debts run up by all the other partners.
When doing business as a corporation, the corporation may go bankrupt and the shareholders may lose their initial investment, but the creditors cannot touch the personal assets of the owners.
Example: If a person owns a taxi business as a sole proprietor and one of the drivers cause a terrible accident, the owner can be held liable for the full amount of the damages. If the taxi driver was on drugs and killed several people, and the damages amount to millions of dollars more than the insurance cover age, the owner may lose everything he or she owns. On the other hand, if the business is formed as a corporation, only the corporation would be liable, and if there was not enough money, the stockholders still could not be touched personally.
An example that carried this to the extreme follows.
Example: There was once a business owner who had hundreds of taxis. He put one or two in each of hundreds of different corporations that he owned. Each corporation only had minimal insurance and when one taxi was involved in an accident, the owner only lost the assets of that corporation.
Note: If a corporate officer or shareholder personally does something negligent, signs a debt personally, or guarantees a corporate debt, then the corporation will not protect him or her from the consequences of his or her own act or from the debt.
Also, if a corporation does not follow the proper corporate formalities, it may be ignored by a court and the owner may be held personally liable. The formalities include having separate bank accounts, holding meetings, and keeping minutes. When a court ignores a corporate structure and holds the owners liable, it is called piercing the corporate veil.
A corporation may have a perpetual existence. When a sole proprietor or partner dies, the assets may go to the heirs, but the business no longer exists. If the heirs of the business owner want to continue the business in their own names, they will be considered a new business, even if they are using the assets of the old business. With a partnership, the death of one partner may result in dissolution of the business.
Example 1: If a person dies owning a sole proprietorship, his or her spouse may want to continue the business. That person may inherit all of the assets, but will have to start a new business. This means getting new licenses and tax numbers, re-registering the name, and establishing credit from scratch. With a corporation, the business continues with all of the same licenses, bank accounts, etc.
Example 2: If one partner dies, a partnership may be forced out of business. The surviving heirs can force the sale of their share of the assets of the partnership, even if the remaining partner needs them to continue the business. If the other partners do not have the money to buy out the heirs, the business may have to be dissolved. With a corporation, the heirs would only inherit stock. With properly drawn documents, the business could continue.
Stock is the ownership interest in the corporation. The corporation issues shares of its stock to the people or entities who will own the corporation. A corporation can have very few shares of stock or millions of shares. The shares can all represent the same rights in the corporation or there can be different classes of shares with different rights, such as common stock or preferred stock. Stock can be designated with or without par value, which is usually the minimum amount paid for stock.
Ease of Transferability
A corporation and all of its assets and accounts may be transferred by the simple assignment of a stock certificate. With a sole proprietorship or partnership, each of the individual assets must be transferred, and the accounts, licenses, and permits must be individually transferred.
Example: If a sole proprietorship is sold, the new owner will have to get a new license (if one is required), set up his or her own bank account, and apply for a new federal taxpayer identification number and new state tax account numbers. The title to any vehicles and real estate will have to be put in his or her name, and all open accounts will have to be changed to his or her name. He or she will probably have to submit new credit applications. With a corporation, all of these items remain in the same corporate name.
NOTE: In some cases, the new owners of a corporation will have to submit personal applications for things such as credit or liquor licenses.
By distributing stock, the owner of a business can share the profits of a business without giving up control.
Example: If John wants to give his children some of the profits of his business, he can give them stock and pay dividends to them without giving away any management control. This would not be possible with a partnership or sole proprietorship.
A corporation may raise capital by selling stock or borrowing money. A corporation does not pay taxes on money it raises by the sale of stock.
Example: If a corporation wants to expand, the owners can sell off 10%, 25%, or 45% of the stock and still remain in control of the business. Many individuals considering investing may be more willing to invest if they know they will have a piece of the action in the form of tock.
NOTE: There are strict rules about the sale of stock, with criminal penalties and triple damages for violators.
A corporation is required to keep its bank accounts and records separate from the accounts of its stockholders. A sole proprietor or partnership may mix business and personal accounts, a practice that often causes confusion in record keeping and is not recommended.
There are several tax advantages that are available only to corporations, such as:
- Medical insurance for families may be fully deductible
- Tax-deferred trust can be set up for a retirement plan
- Losses are fully deductible for a corporation, whereas an individual must prove there was a profit motive before deducting losses
Shares of a company can be distributed more easily with a corporation than with a partnership. Heirs can be given different percentages and control can be limited to the appropriate parties.
The name of a corporation often sounds more prestigious than the name of a sole proprietor. John Smith d.b.a. Acme Builders sounds like a lone man. Acme Builders, Incorporated sounds as if it might be a large operation. It has been suggested that an individual who is president of a corporation looks more successful than one doing business in his or her own name. The appearance of a business starts with its name.
Separate Credit Rating
A corporation has its own credit rating that may be better or worse than the shareholder's personal credit rating. A corporate business can go bankrupt and the shareholder's personal credit will remain unharmed. Conversely, one shareholder's credit may be bad, but the corporation will maintain a good rating. For example, if one shareholder gets a judgment against him or her, this would usually not affect the business of the corporation, whereas it could put an end to a business that was a partnership.