Forming A Corporation-Advantages and Disadvantages

In continuing the look at appropriate business entities for small businesses, in this article, I’m going to look at some of the advantages and disadvantages of a regular corporation or what’s referred for tax purposes as a C corporation.

Corporations are formed under state law. A corporation is a separate entity that is formed by filing Articles of Incorporation with a state. Usually, a small business owner wants to incorporate for any or a combination of the following reasons:

Being a separate entity, the corporate form may be able to provide some limited liability for the business owner.

Also, being a separate entity, the corporation can borrow money on its own.

And, it’s easier to transfer ownership interests in a corporation than with a sole proprietorship. If a business owner wants to sell an interest in his business to another person, all he has to do is sell the other person stock in the corporation.

A small business can appear to be bigger just by being a corporation. And, a small business owner may find that some clients, such as government entities, will not do business with a sole proprietor, but will do business with a corporation.

The business owner may be able to save taxes by being incorporated. For example, as mentioned in my last article, a business owner may have to pay self-employment taxes as well as income on all his net income on a Schedule C, but if this same business owner is incorporated, he can pay himself a salary from the net profits and leave the rest of the profits in the corporation on which he would only have to pay a tax rate of 15% on the first $50,000 of net income.

However, the corporate form of business entity can be burdensome to work with for the following reasons:

Corporations can be time-consuming and/or expensive to set up as the documents forming a corporation have to be properly submitted to the appropriate state agency. Although now, incorporating online seems to help eliminate some of the cost of incorporation.

With a corporation, it’s more difficult to pull money out of the corporation. If the owner takes money out as a dividend, the dividends are taxed to the business owner on the business owner’s personal tax return, but the dividends are not deductible to the corporation. If the business owner takes money out as salary or wages which are deductible to the corporation, then he must file the appropriate payroll tax return, withhold taxes from his salary or wage and submit the withholdings to the appropriate government agencies, and also, give himself a W-2 at the end of the year.

Putting money into the corporation is also more involved. For example, if a business owner needs to loan money to his corporation, then he needs to document the loan so that when the money is repaid, he can prove to the IRS that the money is a nontaxable repayment of a loan.

The corporation will need to file its own federal and state tax return which means that the business owner has to deal with the time and expense to prepare the corporation’s tax returns.

A corporation may have to pay to the state it’s registered in a minimum amount of franchise taxes and fees every year just to keep its corporate status. For example, in North Carolina, a corporation has to pay a minimum franchise tax of $35 and an Annual Report fee to the state of NC just to keep the corporate status active. (A franchise tax is a tax on the privilege of doing business in a state.)

As you can see, forming a corporation involves many considerations. The tax implications should certainly be discussed with a tax professional. In future articles, I’ll be discussing some other choices of business entity for the small business owner.