Corporations: The Pros and Cons

A corporation is a legal entity recognized and created by the state law in which it is headquartered.

It is considered to be a unique entity that is separate and apart from its owners.

The Corporation substitute itself for its owners in conducting a business such as entering into contractual agreements or incurring liabilities. This means that a corporation can buy assets, obtain credits, conduct business with customers and vendors, open business accounts using its own legal entity and not the owners.

The owners of a corporation are called shareholders. The shareholders elect a board of directors to oversee the major policies and decisions.

The corporation has a life of its own and does not dissolve when ownership changes.

What are the Advantages?

  • Limited Liability – The biggest advantage of a corporation is the limited liability for shareholders with regards to the debts or judgments against the corporations. Shareholders’ lost is limited to the amount of their investment and creditors cannot come after the personal assets of the shareholders if judgement are not satisfied by the business.
  • A corporation has an infinite life – This means that it does not end when there are changes in ownership, withdrawals or deaths of some of the shareholders.
  • Easy Transfer of Ownership – Ownership can be transfered easily without consent from other stockholders.
  • Structured Management – Corporations can have officers and board and directors to handle the different aspects of the business.
  • Raising of capital – Corporations can raise capital much easier than other forms of business because  of the nature of investors that they can attract. In addition, they can raise additional funding through public offering and potentially increase the value of the business when shares are traded in the stock market.

What are the Disadvantages

  • Complexity of formation – The process of incorporation requires more time, additional paperworks, and would cost more money than other forms of business.
  • Subject to more government regulations – Because corporations are monitored by federal, state and some local agencies, corporations are required to comply with regulations both a the start-up phase and on an annual basis.
  • Annual Formality Requirements – You must have an annual stockholder meetings even if you are the only stockholder, annual board meetings to approve major issues, and keep corporate minutes. If you are non-compliant, you may lose the privileges of limited liability and you may end-up responsible for the corporations debts and judgments.
  • May have to pay a minimum tax liability to the state – Some states requires corporation to pay a minimum tax liability. This is a big disadvantage especially if you have a net loss since for federal tax purposes this is not the case. As an example, the State of California requires a minimum tax payment of $800 per year.
  • Double taxation – Profits are taxed at the corporate level and the dividends distributed to the shareholders are taxed again on their personal tax returns unless an S Corporation is elected (see below)

Making an S Corporation Election

If you are a small business owner, you can avoid the double taxation disadvantages of a regular corporation by electing to be an S Corporation- usually done by filing Form 2553 (Election by a Small Business Corporation) within the first 75 days of the tax year to the IRS if you want to operate as an S Corporation for the tax year.  There is no double taxation because all the income and losses flows through the shareholders.

For a single shareholder S Corporation, it is treated as if you were a sole proprietor and for multiple shareholders it is treated like a partnership. The difference lies on how you report the earnings as S Corporations report earnings using Form 1120-S (and Form 1120-S K1) and while sole proprietorship and general partnership uses Schedule C. If you make a certain amount, you may not have to pay self-employment taxes on some of the earnings that normally applies to sole proprietorship and general partnerships.

However, S Corporation have very strict requirements in order for you to qualify:

  • You must have fewer than 100 shareholders – So you can say that the IRS definition of a small business is having fewer than 100 shareholders only.  However, a husband and wife counts as  one stockholder only.
  • The corporation must be a domestic corporation – the corporation must be formed in the United States.
  • Only Selected stockholders are allowed – Only individuals and certain trust and estates can be stockholders. Financial institution, insurance companies, domestic international sales corporations, partnerships and corporations are not allowed to be stockholders. In addition, stockholders must not be a non-resident alien to qualify.
  • You can only have one class of stock. You cannot have both common stocks and preferred stocks that are usually available to regular corporations.

If you fail any of the above test, you will be converted back to regular corporation and you will end up missing out on the tax benefits.