When advising clients that are getting ready to start a business or looking to protect assets, generally the first question that arises relates to the type of entity that they should form. Unfortunately, there is no “one size fits all” when it comes to entity structures. Given that there are numerous entity forms available, choosing the right one for a specific situation is challenging if you are unfamiliar with the benefits and drawbacks associated with each option.
Over the next several months we will discuss a few of the different entity forms that are available and detail the advantages and disadvantages that arise in the context of each structure. This month we are discussing corporations.
Introduction to and Benefits of Corporations
Corporations are one of the most common and well known entity forms. Corporations issue stock to their shareholders in exchange for contributions of capital, which can include money, equipment, or other personal or real property that may be integral to the operations of the business. Like most types of entities, corporations provide shareholders with limited liability, meaning that the personal assets of the shareholders are protected from the corporation’s creditors as long as the corporation follows the appropriate formalities (formalities that apply to all entities where liability is limited). Thus, a corporation is worth considering for any business owners that are interested in shielding themselves from personal liability.
Drawbacks of Corporations
Although a corporation may be the right option in certain situations, there are drawbacks associated with structuring an entity in this manner. First, corporations require a lot of formalities that are not necessarily required in the context of other entity structures (e.g., annual meetings of shareholders and directors of the corporation, annual reports to all shareholders, etc.). Second, corporation tax returns can be complicated and often require filing multiple forms and schedules. Therefore, when compared to other types of entities, businesses structured as corporations often incur additional expenses related to tax compliance. Finally, corporations may be viewed as somewhat inflexible when compared to other entity structures. For example, with corporations, shareholders must elect directors and the directors must elect officers. This process must be properly documented and recorded. Thus, the decision-making and documentation procedures necessitated by these management procedures can sometimes be cumbersome for small businesses that have a limited number of shareholders or owners.
When Should I Form a Corporation?
There are, however, several situations in which a corporation is the ideal form for a business. Corporations are often a great way to structure businesses that are seeking some type of private equity financing. The private equity industry has developed systems and procedures related to placing investments with companies seeking to grow and generally require that target companies be structured as corporations. Therefore, if you are starting a business and plan to obtain a significant amount of capital from private equity sources, you should consider structuring your business as a corporation. Additionally, if your business is going to have a large number of shareholders, plans to offer equity options to employees, or expects to issue several types of shares with varying rights (e.g., common and preferred, voting and non-voting), then structuring as a corporation is likely the best way to manage these complex situations as the business continues to grow. Finally, another reason many businesses are structured as corporations relates to taxation. The Internal Revenue Code imposes tax burdens on entities or shareholders based upon whether they elect to be taxed as a C-corporation or as an S-corporation. Each form has different tax consequences, which we will explore in more detail in an upcoming article. For now, however, it is important to understand that the type of entity impacts how the business will be taxed for federal and state tax purposes.
If you are getting ready to start a business, one of your first thoughts should be how to best structure your business in order to ensure that you, as the owner, are not held personally liable for the company’s debts. In the context of a corporation, the planning opportunities are limitless. Although not always ideal for smaller businesses, the corporate form is a favorable option if (i) the business plans to secure financing and capitalization from traditional private equity sources, (ii) the company will have a large number of shareholders, or (iii) the company plans to offer equity options to employees. However, given that each business and its owners have different goals and needs, it is important to sit down with your professional advisers (e.g., accountant, attorney, etc.) before you form an entity in order to determine which structure is best for you.