Incorporation

Related Terms: Articles of Incorporation; C Corporation; Limited Liability Company; S Corporation

Corporate ownership is one of three broad categories defining the legal ownership structure of a business. The other two broad categories are sole proprietorship and partnership. In a sole proprietorship, the owner is personally liable for his or her business's debts and losses, there is little distinction made between personal and business income, and the business terminates upon the death of the owner or the owner's decision to change the legal character of the firm (by relinquishing part or all of his or her ownership in the enterprise). A partnership is merely joint ownership, and in terms of personal liability, is similar to a sole proprietorship. Sole proprietorships and partnerships are categories of business ownership that may be entered into and dissolved fairly easily. Incorporation, on the other hand, is a more complex process. Incorporating involves the creation of a legal entity that serves as a sort of "person" who can enter into and dissolve contracts; incur debts; initiate or be the recipient of legal action; and own, acquire, and sell goods and property. A corporation, which must be chartered by a state or the federal government, is recognized as having rights, privileges, assets, and liabilities distinct from those of its owners.

In the 1990s, a new form of business structure became available to those operating businesses in many states. By the year 2002 this form, the limited liability company (LLC) or limited liability partnership (LLP), was available in all 50 states of the union and has become the business form of choice for newly formed businesses. These limited liability entities are the only forms of business structure other than the corporation in which the personal liability of the owners is limited. This feature accounts for their popularity. For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice of business structure. However, there are situations in which incorporation may still be preferable. If a company wishes to do any of the following three things, incorporation is preferable to forming a limited liability company: 1) The company expects to have multiple investors or offer stock to the public; 2) The company wishes to offer extensive fringe benefits to owner-employees, and/or 3) The company hopes to use stock options or stock bonuses as part of an incentive program. In each of these three instances, IRS rules regulating corporations makes the desired activity either possible or more easily done than would be the case for limited liability companies.

Prospective entrepreneurs and established business-people operating sole proprietorships and partnerships are encouraged to weigh several factors when considering incorporating. Indeed, incorporation can have a fundamental impact on many aspects of business operation, from taxes and document keeping requirements to raising capital and owner liability.

ADVANTAGES OF INCORPORATION

• Raising Capital—Incorporation is generally regarded as an indication that the owners are serious about their business enterprise, and intend to devote time and resources to the venture for a significant period of time. This factor, as well as the reporting requirements of incorporation and—in some cases—the owners' more formidable financial resources—make corporations more attractive to some lending institutions. In addition, corporations have the option of raising capital by selling shares in their business to investors. Stockholders know that if the business they are investing in is a corporation, their personal assets are safe if the company gets into litigation or debt trouble.
• Ease of Ownership Transfer—Ownership of the company can be transferred fairly easily by simply selling stock (though some corporations attach restrictions in this regard).
• Tax Advantages—Some businesses enjoy lower tax rates under the incorporated designation than they would if they operated as a partnership or sole proprietorship. For instance, business owners can adjust the salaries they pay themselves in ways that impact the corporation's profits and, subsequently, its tax obligations. It can also be easier for a business to invest in pension plans and other fringe benefits as a corporation because the cost of these benefits can be counted as tax-deductible business expenses.
• Liability—This factor is often cited as far and away the most important advantage to incorporation. When a company incorporates, the shareholders or owners of the corporation are liable only up to the amount of money they contribute to the firm. Moreover, while a corporation can be targeted in legal actions such as lawsuits, the personal assets of the company's owners cannot be touched if a judgement is rendered against their establishment since it is recognized as a legal entity separate from the owners/shareholders.

Still, while incorporation provides business owners with far greater liability protection than they would enjoy if they operated as a standard partnership or sole proprietorship, business experts note that certain instances remain wherein the personal assets of business owners may be vulnerable:

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