The Advantages and Disadvantages of Incorporation

Posted February 27th, 2012

Why Is This Topic Important to Financial Professionals? This article discusses the benefits and detriments of corporation business structures for use in financial planning.

Advantages

Perhaps the most advantageous reason for the formation of a corporation at the state level is the “corporate veil”—a term of art meaning that corporate shareholders are not held personally liable to the creditors of the corporation for any and all debts of the corporation.  On the other hand, a sole proprietor is personally liable for the debts of his or her business.  If the business incurs significant debts that the business does not satisfy, then the issue arises of who will the creditors pursue for the money?  A traditional corporation is one way to protect personal assets from the liabilities incurred by the business enterprise.

Another advantage of a corporation is the going concern concept.  A corporation, as a separate legal entity from its owners, will not automatically dissolve upon the death of the owner(s), unlike a sole proprietorship.  Succession planning often takes into consideration multiple generations, and the ongoing concern of the business is generally an integral part.

Access to capital is also an advantage of corporate structures.  Generally, investors are more likely to invest in a corporation that is a going concern than a sole proprietor.  Banks and other institutions may have separate lending standards for incorporated organizations.

Disadvantages

The most common concern with corporations for most people is the issue of double taxation.  This occurs when the corporation is required to pay corporate income tax on its profits each year.  Once distributions are made to shareholders, taxes are again levied on the personal income of the stockholder, which includes the distribution.  Therefore, a tax is levied at the corporate level and the personal level on the same income, hence the term double taxation.

To avoid this issue, in 1958 Congress “acted on President Eisenhower’s recommendation” and created a Subchapter S of the Internal Revenue Code.[1] Subchapter S-Corporations (commonly referred to as “S-Corps”) have several advantages for small businesses over traditional corporations (which are known as Subchapter C-Corporations), including the elimination of double taxation.

Generally, the expense to form and maintain a corporation will be higher than costs associated with sole-proprietorships.  Corporate filing fees in the first and subsequent years will be incurred.  As well, the costs related to the accounting and tax preparation will usually be higher with a corporation than a proprietorship.  (Financial planners with an accounting background may provide their clients the accounting and tax preparation services for additional fees).  Also, stockholder annual meetings and recording minutes can add additional costs to corporate structures.

Alternatives

Since there are limitations on the structure of an S-Corporation, most states now offer alternative structures that have several advantages over S-Corps.  These may include Limited Liability Companies (known as LLCs) and Limited Liability Partnerships (known as LLPs).  In general, for an LLC there is no limitation on the number of shareholders or classes of stock such as with S-Corporations.  The S-Corporation Association notes that “the number of LLCs has grown nearly ten-fold since 1995, rising from fewer than 120,000 to more than a million today.”

For a detailed analysis of the tax and non-tax Advantages of a Close Corporation see AdvisorFX Main Library Section 14. Close Corporations G—Professional And Executive Corporations


[1] S-Corp.org, “S-Corp History” Link.  http://www.s-corp.org/asp/products/product_3_4.asp.  Last Accessed 6/17/10.

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