Incorporating a business is a pretty exciting step to take. It’s the culmination of a dream achieved, a job well done, and the ability to take the next steps on an entrepreneurial journey. Many businesses must decide if incorporating is the right choice to make for their business structure because it may not actually be the best type of business to create. There are certainly advantages that come with incorporation, but there are some disadvantages that must be considered as well.
If you’re thinking about incorporating a business today, then here are some of key issues to considered before finalizing the decision.
What Are the Pros of Incorporating?
1. There are limited personal liabilities.
The owners of a business that is incorporated have an advantage of limited liability from a personal standpoint. Corporations are considered their own legal entity and so any debt or expenses that occur are associated with the business and not with the individual owners. Claims against assets therefore go against the business as well and not to the owners or the shareholders. Even in bankruptcy, an owner’s personal assets are not placed at risk.
2. It’s the perfect structure to attract investors.
Corporations are able to issue stock, which means it is a lot easier to find investors who are willing to support a business. Shareholders can invest capital now and then receive a return on their investment over time. This means everyone has something at stake when it comes to growing the business, even if it is a small ownership group or an incorporated business of one reporting to a board of directors.
3. Corporations can create their own power structure.
The chain of command that a corporation installs is uniquely their own. Many run with a board of directors that is headed by a President and then have a CEO at the helm. Some corporations have the same person fulfill the role of CEO and President. Others have more than one person share these responsibilities. The advantage here is that officers, shareholders, directors, and everyone else has specifically assigned duties within the framework of the business that are unique to them with clear definitions.
4. Benefits can include stock options for workers.
Incorporating also gives businesses large and small the chance to offer a unique benefit: stock options. For a job well done or as part of a bonus program, the right to buy stock at a price which gets locked in can be a tremendous incentive to help the business grow. Here’s why. Let’s say the stock of ABC Inc. today is valued at $9.85. The stock price for options gets locked in at $9.50. In 3 years, the market value is $42.15 per share. Employees can buy their options at $9.50 and then sell them once they’ve met their holding obligations. 1000 shares at $30+ profit per share is a nice bonus, right?
5. There are different types of incorporation as well.
Incorporating will be either as a C-Corp or as an S corp. The S corp incorporation is primarily designed for those one-person corporations so that they don’t have to face double taxation. One tax report can be filed from personal shareholders of the business instead of the wages and profits being taxed independently. The paperwork and qualifications for this tax structure are quite complicated, however, so the costs of hiring an experienced attorney for consultation may be more than the double taxation burden.
6. Corporations have a bigger and broader reach.
Incorporating gives a business the chance to reach a broader overall audience. This is because investor capital can be used to create brand recognition to varied demographics on a mass market scale instead of being forced to build up from niche expertise at the very beginning. When done correctly, this also means the chance for a higher level of profitability. More money means attracting experienced workers, which then creates more money, and the cycle of profitability continues to expand.
7. Incorporating means a perpetual existence unless liquidation occurs.
In other business structures, owners can decide to pull the plug at any given moment if they decide there isn’t value in continuing. A corporation exists perpetually until all of the shareholders decide to liquefy the assets or merge them into another company. The company continues even if the original owners leave the business, which can be very attractive to shareholders.
8. Corporations can change their structure.
A C corporation can change their status to an S corporation by March 15 of any given year if they operate on a standard calendar year with their budget. As long as they meet the qualifications of an S corporation, such as not exceeding a maximum number of investors, then there is a chance every year to make this happen. An S corporation can also switch to a C corporation.
What Are the Cons of Incorporating?
1. There are heavy tax liabilities.
Corporations are unlike other types of business in the fact that they must file a specific income tax return every year. Although there are plenty of deductions, incentives, and credits that are available to businesses, it means that ultimately some corporations experience a double taxation. Here’s why: in a one person corporation, the business income is taxed independently of the wages that are being paid to oneself. Those wages are also taxed. That’s why a one-person incorporation may not make much sense in certain circumstances.
2. There must be complete documentation of every activity and transaction.
The paperwork demands for an incorporated business can be overwhelming. Board meetings, conferences, and meetings with shareholders must all be appropriately documented. Financial transactions must be recorded in fine detail. This process begins with the articles of incorporation that are mandatory upon creating the business and continue on indefinitely so that the business can remain in good standing. Every state has different reporting regulations, which can be problematic in numerous ways as well.
3. There may be a tax prepayment requirement.
For franchises that are operating in their first year, there may be an extra fee added to the filing costs for the paperwork required to incorporated. That’s a tax prepayment on expected first year revenues that have been budgeted. If a business expects to have a taxable income of $100k and the business tax rate at the state level is 9%, then incorporation would require a $9,000 fee on top of all the other fees. That can quickly kill incorporating for some small business owners.
4. It can be a one strike and you’re out atmosphere.
The rules and regulations of incorporating must be strictly followed in order to maintain the status of the business. If an audit shows that the rules have not been followed, even unintentionally, then there is the possibility of having all the benefits of being a corporation revoked. The polices that govern compliance are very thorough and extensive, which often means someone within the corporation must be working on compliance issues on a regular basis.
5. Credibility doesn’t happen as it once did.
Incorporating might be able to help a business be able to protect its name within a specific region, but it doesn’t automatically convey the same respect that it once did. In the past, an incorporated business had a certain level of respect because there was a lot of work that had to go into keeping that status. Too many businesses have scammed too many people over time for trust to happen through recognition. You have to earn your credibility today and sometimes that respect never comes.
6. S Corps have limits to the number of investors that are allowed.
A C corporation can have as many investors as they want. They can generally be from anywhere in the world, although some exceptions are in place for nations that have trade restrictions. On the other hand, an S corporation is limited to 100 shareholders at maximum. Every shareholder must also be a US citizen. This means the S corp must generally seek funding from business angels or venture capitalists instead of looking to raise money through stock equity.
7. A corporation can only change their status once in a year.
Business decisions must be made with great consideration because status changes are only allowed once per year. The biggest difference is in the amount of money and type of shareholders that each corporation may have. Many of the formal requirements are the same, which is why there is such a limitation in place for how the business can be operated.
8. LLCs often qualify as an incorporation.
The LLC is a limited liability corporation that has only recently been allowed in all 50 states. There are fewer formal requirements, but the same liability protections in place. Only personal income is taxed, but these companies cannot go public, issue stock, and income often qualifies as self-employment income. This can dilute the business field in certain industries, creating higher costs.
The pros and cons of incorporation show that when taxes are handled carefully, the benefits of higher profitability often outweigh the risks involved. There are challenges that exist in the operations of every business, but when it comes to incorporating, those challenges can be greatly rewarded.