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WHY USE THE CORPORATE
STRUCTURE?
Introduction:
Most businesses
start out with little money, great expectations, and a willingness to
work hard on the part of their owners. With budgets tight and income not
yet coming in, each expense is carefully considered and all expenses not
vital put aside until more money is available. Given such restrictions,
most entrepreneurs put off considering the incorporation of their entity
until more money is available, and often years after the business starts.
Sometimes the decision is put off indefinitely.
And that is a major mistake. The benefits of
incorporation of a business entity are not only of critical importance
but are actually of greater import at the dangerous commencement of a
business when the odds of insolvency are greatest and the risks of debt
the most extreme. While incorporating (or creating a limited liability
company) is usually a good idea, it is more likely to be
of greater utility at the beginning of your business life.
This article will outline why.
THE FIVE BASIC BENEFITS OF INCORPORATION:
- Limited
Liability
If one incurs a debt, one either pays it in a timely
manner or faces litigation which, if resulting in a judgment, can result
in attachment of one’s own bank account, real property, or earnings.
On the other hand, if a judgment is rendered against a corporation, the
judgment is valid only against the corporate assets, NOT against the
individual assets of the owners (unless they violated certain corporate
procedures allowing
piercing the corporate veil)
or unless they executed
personal guaranties, both
discussed in other articles on this web site.
This allows one to engage in the risky business of
being an entrepreneur without necessarily risking all that you own if the
business fails.
Is that a realistic fear? Most businesses fail in the
first three years of their existence. The ability to obtain limited
liability and thus limit the risk of the new business venture is
considered by many the single greatest advantage of incorporating.
- Separate
taxable entity available
With a corporation
one has the option of creating a “new” tax payer, namely the
corporation itself. It can often have a different taxable year which
allows remarkable tax planning of great use to many individuals. It
allows one to determine when to transfer income tax wise to the owners or
employees, when to keep the cash in the company to avoid individual
taxes, etc.
And if the separate taxable entity is no longer
useful, one can elect a method of tax treatment called Subchapter S which
allows the corporation’s income or losses, in most circumstances,
to be taxed to the individuals directly. One can even alter one’s
method of taxation every so often between having the corporation be a
separate tax entity (Chapter C) or taxed to the individuals (Subchapter
S.) Note that the other limited liability entity often considered by
entrepreneurs, the Limited Liability Company, is not a separate taxable
entity.
- Special
Tax Benefits Available
Certain very
valuable tax benefits, from the 401K Pension Plans to various tax
credits, have historically only been made available to the corporate
structure and not to individuals. Some, such as the 401K, are far
superior in many ways to the IRAs or SEPS plans available to other types
of business structures.
- Good
Structures Available for Shared Control
More than most types of structures, corporations allow
very flexible but fully enforceable structural planning to be
implemented, and such traditional problems as what occurs when one has a
minority owner who becomes hostile, or what occurs if an owner dies or
becomes disabled are easily handled with such traditional corporate tools
as the Buy
and Sell Agreement or other types of corporate structural
methods. These tools have been tried and tested in the hundred years that
corporations have existed, have a long history of success, and can avoid
the usual problems that often destroy the sole proprietorship or
partnership. Competent legal and tax counsel can easily create a mix of
internal structures within a corporation that can handle almost any
conceivable problem that can occur to a new business owner and can
intermix within a corporation various checks and balances that can assure
efficient and fair operation of the business. No other entity has such
flexibility in structure combined with a long history of testing the
viability of such structures in tens of thousands of instances in the
past.
- Continued
Survival of Business Despite Change of Owners
Death, divorce,
moving to a new location, or merely an alteration of one’s own
plans can wreck havoc on a typical small business. It is important to
note, however, that unlike sole proprietorships, the corporation can
exist despite change of ownership and quite often the customer need not
even know that a change in ownership has occurred. This ability of the
company to alter ownership without the company itself appearing to change
gives the corporation a life above and beyond that of its owners and
explains why all the largest companies are corporations…and why
most small companies seek to be corporations as soon as they can.
This also allows the
corporation to spin off divisions or assets into other related entities
or even sell them and still maintain the core business and the core
identity.
THE DOWNSIDE
OF INCORPORATION
1.
Cost
While California
once passed a waiver of the minimum franchise (state income) tax on
certain small corporations for the fist year, this benefit can no longer
exist in a nearly bankrupt state and there is still a minimum of
approximately nine hundred dollar a year tax that must be paid from the
second year onward even if no income is achieved. Further, the
incorporation process, need for additional accounting books, need for CPA
and attorney advice, and need to purchase the corporate minute book,
stock certificates, and seal do add up. Even without the minimum franchise
tax, expect the cost to incorporate to equal a thousand dollars with
perhaps five hundred dollars additional for the CPA fees. (Most law
offices, including ours, charges a flat five hundred dollars for this
incorporation process but those firms which charge by the hour could
result in fees perhaps five hundred dollars above this estimate.)
Assuming the minimum franchise tax must be paid in the first year, expect
that incorporation will normally cost about two thousand dollars, though
half of that are taxes merely being paid in advance.
2.
Time
One must have the
first meeting of the incorporators and board of directors of the
corporation, must learn the basics of how to run it by having meetings
with attorneys and CPAs, and, at least once a year, must have meetings of
the board of directors and shareholders and keep minutes. Expect the
initial incorporation process to take ten to fifteen hours of your time
and each year’s process about five hours of your time.
3.
Need to open corporate bank
account and set up corporate stationary, signage, etc.
To avoid the
appearance of not being a corporation (and maintain full limited
liability benefits,) it is important to make sure that all third parties
are aware of your status, thus adding the words, “Inc.” or
“incorporated” to all stationary, invoice, etc. if important.
To do otherwise is to risk “piercing the corporate veil.”
Setting up separate books, accounts, stationary and the like for the new
entity can run into tens of hours of your time and hundreds of dollars in
costs.
4.
Withholding Taxes
One is an employee
of one’s own corporation if one receives a salary even if one is
the sole owner and under IRS law, one must therefore withhold taxes as
one would with any other employee. While payroll services can easily
handle this obligation, it must be remembered that the owners, if
receiving a salary, must also go through the full withholding procedure
with its added complications and costs.
WEIGHING THE
COST BENEFIT
As one client put
it, it is seldom that the law allows you to become two people and to use
your “other person” for business, structural and tax planning
almost at will. While some additional time and some money is required,
the usefulness of the corporate structure is probably best attested to by
the fact that virtually any large or even medium sized entity adopts the
corporate structure. If one looks around the world, one quickly notices
that the overwhelming majority of successful people have, without hesitation,
elected to use the corporate structure and clearly they would not have
done so if the benefits were not worth while.
Certainly anyone with assets they seek to protect or
who faces the complexity of multiple ownership should seriously consider
the usefulness of the corporate structure and even those businesses which
determine that it makes more sense to wait before incorporating should do
so the moment the success of their company makes protecting personal
assets important.
One wit quipped that the world has only one class of
truly first class citizens: the corporation.
And one can incorporate in less than a week, spending
less than two thousand dollars and enjoy the benefits for as long as one
is in business.
It is probably the best money that a new company can
invest to achieve limited risk, a good and proven structure, and a myriad
of tax planning advantages. It is almost always a worthwhile decision to
incorporate or consider the other limited liability entity, the limited
liability company, discussed elsewhere on the website.
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