Comparing Corporations to Sole Proprietorships and Partnerships
Corporations enjoy many advantages over partnerships and sole proprietorships, but there are also some disadvantages to consider.
Advantages of a corporation versus a sole proprietorship or partnership
Shareholders in a corporation are not liable for corporate debts
This is the most important attribute of a corporation. In a sole proprietorship or a partnership, the owners are personally responsible for business debts. If the assets of the sole proprietorship or partnership cannot satisfy the debt, creditors can go after each owner's personal bank account, house, etc. to make up the difference. On the other hand, if a corporation runs out of funds, its owners are usually not liable.
Please note that under certain circumstances, an individual shareholder may be liable for corporate debts, if, for example, a shareholder personally guarantees a corporate debt. Also, under certain circumstances, a court may determine that justice requires disregarding the corporate form and treating the acts and liabilities of a corporation as the acts and liabilities of the shareholders. This is sometimes referred to as "piercing the corporate veil." Some of these circumstances where a court may decide to pierce the corporate veil include:
- If personal funds are intermingled with corporate funds
- If a corporation fails to have director and shareholder meetings
- If the corporation has minimal capitalization or minimal insurance
- If the corporation fails to pay state taxes or otherwise violates state law (like defrauding customers)
Corporations offer self-employment tax savings
Earnings from a sole proprietorship are subject to self-employment taxes, which are currently a combined 13.3% on the first $106,800 of income. With a corporation, only salaries (and not profits) are subject to such taxes. This can save you thousands of dollars per year.
For example, if a sole proprietorship earns $80,000, a 13.3% tax would have to be paid on the entire $80,000. Assume that a corporation also earns $80,000, but $35,000 of that amount is paid in salary, and $45,000 is deemed as profit. In this case, the self-employment tax would not be paid on the $45,000 profit. This saves you over $5,000 per year. Please note, however, that you should pay yourself a reasonable salary.
Corporations have continuous life
Unlike a sole proprietorship or partnership, a corporation does not expire upon the death of its shareholders, directors or officers.
Corporations make raising money easier
A corporation has many avenues to raise capital. It can sell shares of stock and create new types of stock, such as preferred stock, with different voting or profit characteristics. Plus, investors can rest assured knowing they are not personally liable for corporate debts.
Transferring the ownership interests of a corporation is easier
Ownership interests in a corporation may be sold to third parties without disturbing the continued operation of the business. A sole proprietorship or partnership, on the other hand, cannot be sold whole. Instead, each of its assets, licenses and permits must be individually transferred. Plus, new bank accounts and tax identification numbers are required.
Advantages of a sole proprietorship and partnership versus a corporation
Sole proprietorships and partnerships cost less to establish
Corporations cost more to set up and run than a sole proprietorship or partnership. For example, there are the initial formation fees, filing fees and annual state fees. However, these costs are partially offset by lower insurance costs.
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Sole proprietorships and partnerships have minimal formalities
A corporation can only be created by filing legal documents with the state. In addition, a corporation must adhere to formalities. These include holding director and shareholder meetings, recording corporate minutes and having the board of directors approve major business transactions. If these formalities are not maintained, the shareholders risk losing their personal liability protection. While keeping corporate formalities is not difficult, it can be time-consuming.
On the other hand, a sole proprietorship or partnership can open and operate without any formal organizing or operating procedures - not even a handwritten agreement.
Sole proprietors and partners are not liable for unemployment insurance
A shareholder-employee of a corporation is required to pay unemployment insurance taxes on his or her salary, whereas a sole proprietor or partner is not. Currently, the federal unemployment tax is 6.2% of the first $7,000 of wages paid per year, with a maximum of $434 per employee.
If you pay any required state unemployment tax, you can receive an offset credit of 5.4%. This effectively lowers the federal rate to 0.8% with a maximum of $56.00 per employee per year.