Business owners often consider whether they should incorporate or organize their business in some other way. There are a number of factors that should be considered. Such factors include limitation of liability, control, perpetual existence, transferability, taxes and marketing.
A primary reason given to incorporate is to limit liability. A corporation is a separate and distinct entity from its owners, but it has the same rights and obligations as an individual. For instance, a corporation can own property, carry on business, incur liability, and it can be involved in litigation. A shareholder’s liability is limited generally to the value of the cash or other property contributed to the corporation in exchange for stock. Therefore, as a general rule, the shareholder’s assets not invested in the corporation are safe from the corporation’s creditors, and a shareholder is not personally liable for the debts of the corporation.
However, there are two primary exceptions to this general rule. The first is if the shareholder provides a personal guaranty. A personal guaranty is often required by lenders, vendors, landlords or other key creditors. The second primary exception is for tort liability. For instance, if an owner of a corporation is negligent and causes damage, then the owner is personally liable for the damage even if the owner has incorporated its business. Because an owner of a small corporation is actively involved in the business, the tort liability exception can be a significant exception. Nevertheless, if the business has employees, it is necessary to incorporate to shield the owner from the negligent acts of employees. Accordingly, if a business has employees, it is generally a good idea to incorporate (or form a limited liability company).
In addition to the two primary exceptions to limited liability, a shareholder may become personally liable for corporate debts if the corporation is not formed in compliance with, or operates in violation of, applicable statutes, or if the corporation is operated as a mere front for its shareholders rather than for corporate purposes. Under some circumstances, corporate officers may be held personally responsible for the corporation’s failure to pay state and federal income tax withholdings.
The business affairs of a corporation are managed by its board of directors and its officers. The directors are elected by the shareholders. While shareholders have the ultimate control of a corporation because of their stock ownership, the day-to-day management lies with the board of directors through its officers.
When a corporation has a large number of shareholders, such day-to-day centralized management by the board of directors and officers can be an advantage. This division of responsibility and possible conflicts of interest between the shareholders and directors can also create the risk of dissension. In small corporations, the shareholders, directors and officers are often the same person or persons.
A corporation can have a perpetual existence, unaffected by the death, withdrawal or entry of shareholders, officers or directors. The corporation can simply continue its business uninterrupted by such events. To transfer ownership, a shareholder may transfer shares of common stock to a new or existing shareholder. The transfer of ownership by a shareholder to a third party may occur freely unless the shareholders voluntarily agree to restrict the ability to transfer ownership. The ease of transferring shares of corporate stock may facilitate family estate planning, gifts to children, intrafamily sales, transfers between shareholders and compensation to key employees.
This ease of transferring shares of stock can also facilitate the financing of the corporation through the issuance of stock to the general public. Public offerings of stock are subject to numerous federal and state requirements and require the assistance of counsel familiar with these requirements.
Shareholders can enter into an agreement limiting the transferability of shares of stock and providing for certain buy-sell provisions. Such buy-sell provisions can require the sale and purchase of the stock on death, disability, withdrawal from the corporation or other such circumstances.
Corporations may enjoy certain tax advantages but may also be subject to certain tax disadvantages. Because of the complexities involved, anyone considering incorporation should consult with a qualified tax adviser prior to incorporation.
The corporation can adopt a pension or profit-sharing plan for the benefit of the employees. If certain requirements are met, contributions of cash or other property by a corporation to such a plan will be deductible by the corporation for federal income tax purposes, the earnings derived from contributions to such a plan will not currently be subject to tax, and the employees will not be taxed on their share of the funds until it is distributed to them. Under current tax law, there is very little difference between the types of plans that a corporation may adopt compared to a noncorporate business entity. The corporation may be able to provide for its employees tax free: 1) group term life insurance benefits; 2) medical and dental insurance benefits; 3) so-called cafeteria plans; and 4) death benefits. While a noncorporate business entity can provide these same benefits, if the shareholder is also an employee, the shareholder becomes eligible to receive these benefits. (Note: These benefits may be treated differently for shareholders in an “S” corporation.)
Fair or not, often businesses that are incorporated may be perceived as being more legitimate than a business that is not incorporated. If you incorporate, you can use “Company, ‘Inc.,’” “Ltd.,” or similar identification of a corporation in your business name. Such ability to be identified as a corporation may lead to an enhanced image to the general public.
It is important to keep in mind that the factors that have been discussed are the principal considerations to be evaluated in determining whether a business should be organized as a corporation. However, they are not the only considerations. You should consult with an attorney and tax professional to discuss the advantages and disadvantages of incorporating in your particular case.
Legal editor: Anthony J. Motschenbacher, July 2019