To Incorporate or Not to Incorporate ... That is the Question

Michael J. West
Vice President, Investments
Raymond James & Associates

One of the side effects of the various corporate restructuring and early retirement programs in abundance today is an increase in new small businesses. Many newly laid-off or retired executives open their own businesses. Among the first questions a new business owner must ask is, "How will I do business, as a corporation, proprietor or partnership?"

There are generally five major concerns when choosing the form of a new business; liability, financing, management, continuity and taxes. Too many budding entrepreneurs focus only on the tax aspects.

The question of liability is very important in today's litigious society. Generally, a corporation affords the shareholders protection from the creditors of the company. The shareholder’s liability is limited to his/her investment in the corporation. To achieve this limited liability status, various legal requirements must be followed. Ignoring the "technicalities" can result in a corporate creditor being able to "pierce the corporate veil" and go after the shareholder’s personal assets. Also, professionals can't use corporations to shield themselves from malpractice liability. General partnerships and sole proprietorships do not offer limited liability to owner/managers. However, partnerships and sole proprietorships are often easier to establish and often have less "red tape" associated with them.

All businesses need to raise money for operations. The use of the corporate form allows the company to sell shares of stock to new investors to raise money. Corporate ownership may also make it easier to recruit, retain and reward key employees through awards of common stock. Some have argued that corporations may find it easier to borrow than an unincorporated business. However, shareholders are often asked to personally guarantee corporate debt.

The management of the business is also a concern. Theoretically, a corporation is run by its board of directors. As a practical matter it may make little difference if the business is controlled by a single individual. However, if more than one person will be an owner of the business, the dynamics of controlling a business through a consensus of partners versus the use of a board of directors must be carefully reviewed.

Continuity is also an issue. A corporation may have a perpetual existence. Sole proprietorships die with the owner. Depending on state law and the planning that's been done, the death of a partner may result in the dissolution of the partnership.

There are basically two types of corporations for tax purposes; C corporations and S corporations. A C corporation is a separate tax paying entity. C corporations have graduated federal tax rates from 15% to over 35% (although professional corporations pay a flat 35%). C corporations are subject to the corporate Alternative Minimum Tax. C corporations are subject to the accumulated earnings tax. Under S corporations, any income or loss flows through to the personal returns of the shareholders. In effect, regular corporate income is taxed twice, once to the corporation and again to the shareholders. S corporations are not taxed twice or subject to the corporate Alternative Minimum Tax; however, the individual shareholders are subject to the individual AMT and corporate items may have an impact. S corporations are also not subject to the accumulated earnings tax.

Finally, new forms of business organization are being developed in various states including the limited liability company, corporation and partnership. These new developments and issues discussed should be fully explored before deciding on the proper form for a new business.

Of course, this brief article is no substitute for a careful consideration of all the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.