Benefits of Forming a Corporation

 Choosing the best legal form for your business

Clinton W. Daley 

BizJump Quarterly, 2001 number 2

ne of the first decisions that a single entrepreneur or a group of business owners must make in starting a new business is the legal and tax form of the new entity. Not only is this one of the first decisions, but also it can be one of the most important.

When considering a legal form of business, entrepreneurs have several options to choose from. The most common of these include: Sole Proprietorship, General or Limited partnership, Corporation (whether a C corporation or an S corporation), and Limited Liability Company (LLC). The decision to use one of these forms should be based on a careful analysis of the potential owners, and the legal and tax characteristics of each business form.

Legal Forms of Businesses

1.   A sole proprietorship is established and conducted by a single individual using a portion of his or her assets, dedicating them to business use, and keeping separate books of account for the business. Income and losses from the business are reported on the individual's income tax return. The sole proprietor is fully liable for the debts and other liabilities of the business.

2.   A partnership is an association of two or more persons to conduct a business. In a general partnership, each partner is liable for claims against the partnership. All of the partners in a general partnership may participate in management and each may act as agent for the others. However, in a limited partnership, there must be at least one general partner who is personally liable for claims against the partnership. The limited partners are not liable for claims against the partnership unless they participate in the management of the business. 

3.   A Regular or C corporation can be formed by one or more persons. For both tax and legal purposes, the corporation is treated as a separate entity from its shareholders. The corporation itself is liable for debts and other claims against it rather than the shareholders. Generally, the management of the corporation is centralized with the shareholders electing corporate directors, who in turn elect officers. Although the corporate form is mostly used by large business enterprises, many small businesses are now incorporating to achieve limited liability benefits. In fact, most States are now making it easier for small business owners to form a corporation.

4.   For legal purposes, the S corporation is almost identical to the C Corporation. The only significant difference is that unlike the C corporation, the S corporation is taxed only once -- at the personal level. Most small businesses begin operations as S corporations because the owners are able to write off start up losses from their personal income taxes. Usually, after the business begins to make a profit, the owners usually convert to a C corporation to access greater tax benefits. Not all business entities are eligible for S corporation status. An S corporation may have no more than seventy-five shareholders. Also, a shareholder cannot be another corporation, a partnership or a nonresident alien.

5.   The Limited Liability Company (LLC) is a new type of business entity, which combines the single taxation benefits of the partnership with the corporate characteristics of limited liability. Generally, an LLC can be formed by two or more persons (Some States allow one person LLC). Owners of an LLC are referred to as members. Generally, the members of an LLC can choose to have the LLC managed by a manager or managers by providing for this in the articles of organization. These managers act similar to the directors of a corporation.

Business Form Decision and Benefits of Incorporation

There are six primary factors that a business owner should consider when choosing a legal form of business. These are:  Separate legal entity status, management structure, continuity of existence, ease of financing, transferability of interests, and limited liability.

Separate Legal entity Status

This consideration deals with whether or not a business will be considered a separate legal entity and, therefore, has the right to sue or be sued and enter into contracts in the business name. An incorporated business is always treated as a separate legal entity. However, the sole proprietorship and partnership are not recognized as separate legal entities from the business owner(s). In addition, because of the separate legal status, owners of a “C” corporation are taxed twice — Once at the corporate level and again at the personal level. Most business owners can avoid this double taxation by forming an S corporation or an LLC, which are only taxed once at the personal level.

Management Structure

The sole proprietorship is simply managed and controlled by the business owner. The management structure of the general partnership is similarly straightforward in that all general partners can participate in the management of the business. A corporation, on the other hand, is required to have centralized management. The shareholders must elect a board of directors who make most of the major operating decisions. For most corporation, the board of directors will elect executive officers; like the president, treasurer and secretary to run the day-to-day operation of the corporation. However, in a closely-held (small business) corporation, it is common for the shareholders, the board of directors and the executive officers to be the same person(s). The corporation is required to hold meetings of its shareholders and directors and keep accurate records and minutes.

Continuity of Ownership

Continuity of existence refers to a business' ability to continue upon the withdrawal, bankruptcy or the death of one of its owners. A corporation automatically has perpetual existence unless otherwise provided for in the articles of incorporation. The corporation, as a separate entity will continue to exist regardless of the death, withdrawal, or bankruptcy of one of its shareholders. However, the death of a business owner will terminate the sole proprietorship or partnership.

Ease of Financing

An important consideration before organizing a business is the extent and type of financing that is required not only at the present time, but in the future as well. A sole proprietorship is limited to personal funds and personally guaranteed loans.

With regard to ease of financing, the C corporation is generally considered to have the most financing flexibility due to the variety of forms of investment participation available. A “C” corporation can issue various types of equity instruments including, common and preferred stock, stock warrants, and stock options. In addition, the corporation can issue bonds, which may or may not be convertible into equity. This form of financing is not available to the other forms of businesses.

The S corporation does not have as much flexibility as the regular C Corporation. First, the S corporation can only have seventy-five shareholders; therefore, once this limit is reached no additional owners can provide capital investment. Second, the S corporation is only allowed to have one class of stock. As a result, the S corporation is limited to owner capital contributions, loans from owners, and loans from outsiders for financing purposes.

Transferability of interests

Transferability of interests refers to the owners' ability to sell or transfer their interests (stock) in the business. The sole proprietorship obviously has complete transferability in that its owner can sell or transfer any portion of the business. The C corporation also has full transferability of interests. In general, there are no restrictions on shareholders with regards to the selling or transferring of their shares.

On the other hand, the S corporation is somewhat restricted. In theory, the shareholders are free to sell or transfer their shares. However, in order to retain S corporation status, a sale or transfer of stocks cannot be to a non-qualifying shareholder or cause the number of shareholders to exceed seventy-five. This can significantly limit the transferability of S corporation interests.

Limited Liability

Perhaps the greatest benefit of incorporating a business is the limited liability provisions. By statute, members of an LLC and shareholders of a corporation all have limited liability with regards to the debts and claims against the business.

In contrast, a sole proprietor is personally liable for any debts or claims against the business. Likewise, the general partners of a limited partnership or general partnership are joint and severally liable for the debts and claims against the partnership. Also, the limited partners in a limited partnership can lose their limited liability status if they take part in the management control of the business.

Which is Right For You

Since businesses and their owners have unique attributes, it’s difficult to say which business form is best, without analyzing the set of circumstances. In conducting this analysis, potential business owners should consider the above six factors in relation to their business venture. For example, if the business that the entrepreneur wants to start is prone to lawsuits and he has personal assets that he wants to protect, and then a Corporation or LLC might be the best choice. (See the table below)

It is important to remember that the initial choice of entity form can provide great advantages or disadvantages for the future of the business. If the initial decision was not the best or if circumstances have changed in such a way as to rendered the initial decision disadvantageous, the entity can be converted. However, this can be a very costly process.

In order to avoid such costly conversions, careful consideration should be given to both the current and possible future needs and desires of the business and its owners. The time and money spent on this decision will be one of the most important investments made by the future owners. 

Clinton Daley
Managing principal
BizJump, Inc.
www.Bizjump.com
718-446-1991
866-813-9701 (Toll-free)
718-504-3769 (fax)

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