The Pros and Cons of Incorporation

The Pros and Cons of Incorporation
By Mary Hanson

Today it is more difficult than ever to decide whether or not to incorporate. Many business owners have a strong desire to form a corporation or other entity in order to shield themselves from the liabilities of the business.

While there is stronger interest in incorporation in order to get protection from personal liability, other aspects of incorporation are less favorable than they have been in the past.

In particular, you can no longer assume that there will be tax benefits. On the contrary, the assumption should be that incorporation will increase taxes and create future tax pitfalls.

In addition, the protection from personal liability may not be very effective for a particular business.

There are also more types of business entities to choose from now, with the introduction of the limited liability company and limited liability partnership as alternative business forms.

Consequently, it is more important than ever to look closely at how the pros and cons of incorporation affect your business.

Liability

Incorporation of a business gives the business a true separate entity status. The corporation is a "person" under the law, and it is this person that engages in contracts, employs employees, pays taxes, and incurs liability.

As a result, the corporation is responsible for its own liabilities, and claims against the business are not necessarily claims against the owners of the business. The idea is that, even if losses, judgments, or other liabilities should wipe out the business, the business owners, as shareholders would only lose their investment, rather than being personally liable for the losses, judgments, or other liabilities.

For example, one of the types of protection benefiting business owners is that the employer of the employees becomes the corporation. Although the business owner is not protected from taking responsibility for his or her own acts, the owner is insulated from liability for the acts of supervisors and others. Both the employee who caused an accident or committed some wrong and the employer of that employee can be held liable. By switching the "employer" role to the corporation, the business owner can avoid a great deal of personal liability that he or she would otherwise bear as the "employer."

It is also possible for a corporation to go bankrupt without exposing the personal assets of the business owner to the liabilities of the business.

While this protection from personal liability is often very real and meaningful, for many small businesses the protection from personal liability may not be significant. Consider the following four types of personal liability:

* personal liability for individual's own acts
* shareholder liability after a piercing of the corporate veil
* personal guarantees
* personal liability imposed by law

Personal Liability for Individual's Own Acts

Every individual has personal liability for his or her own acts, including everything from car accidents to sexual harassment and violent acts. The incorporation of the business does not protect a business owner from the consequences of those personal actions. The business owner can be sued personally for anything he or she does that creates liability.

If a small business is a service business and all services are provided by the owner, the owner may be held personally liable for any claims arising out of the services provided. However, claimants might make claims only against the corporation for a number of reasons. It may just be an oversight, and the business owner may benefit in such a situation, due to what I call the "smoke screen effect."

Piercing the Corporate Veil

Shareholders of the corporation can be sued and held personally responsible for liabilities arising from the business if the "corporate veil" between the corporation and the stockholders is "pierced." This could cause any kind of business liability to be moved from the corporation to the individual.

The "corporate veil" may be pierced if the separate entity status of the corporation is not maintained. In order to maintain this separate entity status, the corporation must be adequately capitalized, the finances of the corporation and the shareholders must be kept separate, and the formalities of having corporate authorization of business activities must be observed.

For more information on piercing the corporate veil, see the business article called "Piercing the Corporate Veil."

Personal Guarantees

If the business owner has guaranteed contracts, or placed contracts in his or her own name, the corporation will not protect the individual from contract claims. The claimant will simply name the individual as the party liable under the personal guarantee.

Personal Liability Imposed by Law

By statute, some liabilities are made personal liabilities. For example, the individual responsible for making payment to the IRS of withheld employment taxes has personal liability for those taxes. California law exposes officers of corporations to personal liability for sales or use tax which has not been paid to the state.

The Separate Entity

Establishing a corporation creates a new taxpayer. The corporation will owe taxes on its taxable income, unless the corporation elects "S corporation" tax treatment. The S corporation treatment, like the tax treatment of limited partnerships and limited liability companies, "flows" the tax consequences of the corporation on to the shareholders.

In some states, no income taxes are imposed at the corporate level. The state of California imposes an annual minimum income tax of $800 on corporations in California, whether the corporation is an S corporation or a C corporation, and also imposes a 1.5% corporate level income tax on S corporations.

Regular corporations (C corporations) are tax-paying entities. Corporate federal income taxes are at rates substantially lower than personal tax rates, up to $100,000. The tax rate on taxable corporate income up to $50,000 is only 15%. The next tax bracket on taxable income of $50,000 to $75,000 is 25%, and from $75,000 to $100,000 at rates of $34%. Above $100,000, therer are two more brackets of 38% and 35%..

While the C corporation offers an opportunity to have income below $100,000 taxed at lower rates, the use of the C corporation subjects the shareholders of a corporation to double taxation. The corporation is taxed on its income and capital gains. When funds are distributed to the shareholders as dividends or other distribution of profits or gains, the funds are taxed again to the shareholder.

When a successful business is sold or liquidated there are usually dividends or capital gains, and the double taxation can be a very heavy tax burden.

The problem of two levels of taxation can often be managed satisfactorily by a small business, so long as the corporate business is carried on, by paying out profits to employee-shareholders as deductible salary or other compensation. This approach doesn't work when there is excessive compensation, when compensation appears to be a dividend, or when the business is sold or the corporation is dissolved.

The "solution" to the double taxation problem of the C corporation may be to elect S corporation status, instead of operating as a C corporation. The flow-through of tax consequences to the shareholder level results in just one level of tax.

However, there are a number of S corporation requirements which preclude many corporations from electing S status. Entities that qualify to elect S corporation status may still choose not to, due to the restrictions imposed on S corporations.

Because of the limitations on S corporations, other types of entities should be considered in structuring any business for which the "pass through" tax treatment is desired. In particular, the limited liability company offers the benefits of the corporation and the benefits of a "pass through" entity, without the limitations of S corporation status.

It is critically important that every business owner have a business "exit strategy" for tax purposes. Today, a business owner cannot wait and handle the tax issues when they arise. Tax consequences build up in the corporation and tax law is unforgiving if you have not planned ahead.

Long term tax planning must be done at the time the decision whether or not to incorporate is made and the decision whether or not to elect S corporation treatment should be made at that time.

Mary Hanson, MBA, Attorney at Law (310) 543-1355 Torrance (Los Angeles County), California USA