The Protection Provided by Business Incorporation

By Business Filings Incorporated

Incorporation is an important step in the life of a business, but unfortunately the true value of incorporating a business is often not seen until the business faces a negative situation, such as a lawsuit or bankruptcy.

A primary advantage of incorporation is the limited liability the corporate entity affords its shareholders (owners). Typically, shareholders are not liable for the debts and obligations of the corporation, thus creditors won’t come knocking at the door of a shareholder to pay debts of the corporation. Conversely, with sole proprietorships and general partnerships, the owner(s) and the business are legally the same; therefore, the personal assets of the owner(s) can be used to pay debts of the business.

One thing to keep in mind is personal guarantees given by shareholders or items such as business loans from banks. Banks often require small business owners, and particularly new business owners, to personally guarantee the business loan. This means that should the corporation default on the loan, the guarantor is responsible for its repayment. In these cases, the limited liability corporations offer to shareholders will not apply.

Limited liability is not the only benefit incorporating a business provides. Incorporation also often helps new businesses establish credibility with potential customers, vendors, employees, and partners. For example, there may be a greater comfort level in doing business with John Smith’s Landscaping Incorporated instead of directly with John Smith.

One other element business owners often take into account when considering incorporation is the feature of unlimited life that corporations possess. Unlimited life means a corporation is not dependent upon its owners. If an owner dies or wishes to sell his or her interest, the corporation will continue to exist and do business. This is not the case with sole proprietorships and general partnerships where the owner(s) and the business are legally the same. For example, if John Smith operates a sole proprietorship and passes away, the business ceases to exist. Other advantages of forming a corporation include:

• Retirement funds and qualified retirement plans, such as 401(k)s, may be set up more easily.
• Ownership is easily transferable.
• Capital can be raised more easily through the sale of stock.
• Management is centralized with a board of directors overseeing the affairs of the corporation and officers handling the day-to-day aspects of the business.

However, corporations are not without disadvantages. The primary disadvantage to a corporation is double taxation. Profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. They are taxed first as income to the corporation, then as income to the shareholder. All reasonable business expenses, such as salaries, are deductions against corporate income and can therefore help minimize the double tax. Further, the double tax can be eliminated by making the appropriate election with the Internal Revenue Service to be taxed as an S corporation.

Other disadvantages of corporations include:

• There is a certain level of complexity and expense in forming a corporation, since the appropriate documentation must be filed with the state and the necessary state fees paid.
• Corporations have extensive record-keeping requirements, and ongoing state requirement such as annual reporting and taxation.
• If a corporation is transacting business in a state other than its state of formation, it may be required to qualify to do business in that other state. This requires additional filings and payment of required filing fees.

Both the limited liability company (LLC) and the S corporation also provide the advantage of limited liability for the business owners. Also, these two entities do not have the disadvantage of double taxation, as both are pass-through tax entities. The LLC and S corporation also have advantages and disadvantages, it’s a good idea to learn about all three business structures when deciding what form your business should take.