Incorporation is the legal process of forming a corporation or company. The result is a legal entity that separates a firm’s assets and income from its owners and investors.
Corporations can be formed in nearly all countries in the world, and are usually identified as such by the use of terms such as “Inc.” or “Limited (Ltd.)”. The process of establishing a company as a separate legal entity from its owners.
How Incorporation Works
Generally speaking, the decision to incorporate is usually made either as a result of the business’s growth and the issues that accompany that growth or when the personal tax considerations of one or more of the owners warrant incorporation.
A corporation creates a shield of limited liability around its shareholders and directors, commonly referred to as a corporate veil. Therefore, incorporated businesses are able to take the risks that make growth possible without exposing the shareholders, owners, and directors to personal financial liability outside of their initial investments.
Corporations are the most widely used legal form of business operation around the world. Most jurisdictions have certain elements in common with regard to a corporation’s formation and organization.
The Creation and Organization of Corporations
As part of incorporation, the “articles of incorporation” must be drafted, which list the primary purpose of the business and its location, along with the number of shares and class of stock being issued. Stock would not be issued by a closed corporation, for example. Shareholders own companies. There can be one shareholder in a small company, but several thousand shareholders in very large and often publicly traded companies.
Shareholders are generally only responsible for paying their own shares. Dividends are the dividends that shareholders receive as owners of the company. Shareholders also elect the company’s directors.
The directors are responsible for the day-to-day operations of the company. The company owes them a duty of care, and they must act in its best interest. They are usually elected every year. In a smaller company, there may be one director, while in a larger one, there may be a dozen or more directors. Directors are not personally liable for the company’s debts unless fraud is involved or specific tax statutes apply.
Advantages of Incorporation
The desired benefits of making the incorporation decision usually include the following:
1. Shielding the company’s principals from personal liability
A corporate business structure has the advantage of maintaining a separate legal identity from its shareholders, directors and officers. As a result, corporations can sue, be sued, enter into contracts, or acquire loans.
In many circumstances, it also protects the shareholders, directors, and officers from personal liability. This is referred to as the corporate veil and is one of the key reasons businesses decide to form corporate structures and incorporate.
Personal assets of the corporate officials, such as real estate or bank accounts, are protected from creditors by the corporate veil.
2. Raising capital by selling stock
Corporations can be private or public, and their stock may or may not be publicly traded. Through the sale of stock or the issuance of bonds, they can raise capital to finance their operations or new investments. The stockholders become the owners, or shareholders, of the company.
The alternative to raising capital by selling stock is accumulating debt, and too often lenders aren’t interested in under-capitalized businesses.
3. Ownership transfer
Incorporation enables the business owners to more quickly and easily transfer ownership from one shareholder to another: Each share of stock has a value and, thus, can be bought and sold at whatever price that value represents.
4. Allow for the adoption of a variety of employee benefits
Having a company incorporated allows a variety of employee benefits (such as the corporation being able to fully deduct employee health insurance premiums paid) that other types of unincorporated entities are unable to provide.
For example, health and accident insurance premiums paid on behalf of a shareholder-employee who is greater than a 2-percent shareholder of the S corporation are deductible by the S corporation and are reported as wages on the shareholder-employees Form W-2, subject to income tax withholding.
Disadvantages of Incorporation
Given the benefits of incorporating, you may assume that you’ll find significant disadvantages to incorporating; otherwise, everyone would do it. The primary disadvantages of incorporating are
1. The cost and hassle of the incorporation procedure
The cost and hassle of going through the incorporation procedure and complying with the public agencies (federal and state) that oversee corporations can be prohibitive.
The act of incorporation can be expensive, especially from the perspective of a budding entrepreneur with limited cash and few or no customers. The cost depends on the state in which you incorporate, but it can range from about $100 to approximately $1,000 for incorporation fees. Plus, the corporation must pay an annual tax that varies by state.
These costs don’t include attorney’s fees or any other fees that may crop up. (Yes, you can incorporate online, but we don’t recommend it. For matters like incorporating, you need a more personal experience — a name and a face to help you through the process.)
Filings can take from a few days to several weeks, again depending on which state you’re in and who’s handling the process within that state. In some states, filings can take up to two months because the secretary of state and county officials must review them.
2. The hassle and potential liability from shareholder lawsuits
There is potential liability from shareholder lawsuits involved in dealing with shareholders: Shareholders have legal rights and often those rights aren’t in tandem with the wishes of the owner.
3. The “double taxation”
The “double taxation” occurs in a C Corporation when dividends are paid. When corporations earn profits, those profits are taxed at the corporate level. If some of those profits are then paid in dividends to company shareholders, company shareholders also must pay income tax on the dividends, hence the term double taxation.