As a small business grows, there comes a time when the owner(s) should consider incorporating the business. A corporation is a separate entity recognized by the state of domicile for the business. It is as if a new life is created. The state acknowledges the existence of this entity and therefore grants limited legal rights similar to those rights possessed by the citizens of that state. Examples of these rights include:
1. Separate Taxation
2. Right to own property
3. Right to sue and be sued in the state’s district and circuit courts
4. Right to petition the state legislature for laws and regulation modifications
6. Due Process
7. And many others
Although it appears to provide tremendous value to a business to incorporate, there are costs and drawbacks. A typical corporation will pay annual fees to the state to maintain its existence, it must pay for a separate accounting and preparation of the tax returns, and it pays its own taxes reducing wealth for the owners.
In reality though, the corporate existence provides many positive attributes that far outweigh the above costs. With good accounting guidance, many small corporations can reduce and almost eliminate the tax aspect of the above negative attributes. So what are the positive attributes of corporate existence? There are three strong reasons to incorporate. They are 1) protection of owner’s wealth, 2) expanded control over the business legacy for family purposes, and 3) separation of the owner and family from the business. Each of these three positive attributes is explained below for the reader’s understanding:
Protection of the Owner’s Wealth
Most lawyers site this as the only reason to incorporate. The principle is simple; if the corporation creates a legal issue (such as lawsuits, failure to comply, etc.) then the party affected can only pursue the corporation for compensation. A smart owner separates his personal assets from the corporation thus a shield is created (often referred to as a veil) protecting the owner’s assets from the affected party.
Affected parties can only pursue the wealth accumulated in the corporation. As a separate legal entity, the corporation is the entity the affected party must pursue in the state’s court system. The owner’s wealth is protected by law.
There are many misunderstandings about this concept of incorporation. The owner is referred to as a stockholder and in many of the corporation’s transactions the owners (stockholders) must sign away this protection in order to conduct business. Examples include:
- Borrowing money from a bank or lending institution – many banks require the personal guarantee of the stockholders to lend money
- Any compliance for taxation is not protected under the Federal Revenue Code, many state tax codes, and most local government taxation codes. In actuality, many of these taxation issues have criminal statues assigned holding the officers and shareholders responsible.
- Purchases of expensive fixed assets require the owner(s) to be personally liable for repayment of debt
- State professional licensure holds individuals and not the company personally responsible for misconduct (medical, legal, accounting, engineering, etc.)
So you can see it isn’t that simple after all. Just because you are incorporated doesn’t mean you are personally protected. PLEASE SEEK THE ADVICE OF COUNSEL PRIOR TO INCORPORATION TO FULLY UNDERSTAND HOW INCORPORATING WILL AFFECT YOU.
The most common protection the corporation does provide is between you and your employees. When they get physically hurt, there is a strong likelihood your corporation will be sued. In addition, failure to follow good human resources protocols for hiring and termination can result in legal repercussions. It is here that the corporate shield works well in protecting the owner’s personal wealth.
Expanded Control over Legacy
Incorporation allows the small business owner many alternatives to the business life. The most common issue is financial growth via the sale of stock and/or raising more capital. In rare situations, it is possible to go public. Examples of control include the following:
- Raising Capital – the current shareholder(s) can authorize capital investment by selling stock to potential shareholders. In addition, other forms of raising capital are possible including selling preferred stock, issuing bonds, or selling options (rights to ownership).
- Excluding certain assets – the company can generate leases or negotiate rights to certain assets owned or created by the stockholders. This includes patents, copyrights or other royalty based assets. In this situation, the owner or stockholder allow the use of these assets for agreed upon amounts and continue to control the duration or limits of use to the company. This in turn protects the legacy of the family. An alternative is the company owning the assets and then leasing out these rights etc. The key is that with a separate recognized entity, the owner can control the primary or key assets as he deems fit.
- Negotiating partnerships with other corporations or business entities to further mutual growth or expansion. Many business deals falter due to mismatching of entity types. More complex business agreements require the owner to have a corporation to further protect the potential business deal or if the purchase or merging of two businesses is a possibility, incorporation provides an easy method to achieve this.
- Obtaining Government Contracts – many local governments and state governments will only negotiate with an incorporated entity in certain types of contracts. The governments seek reassurance of enough capital to ensure compliance in the contract. Other elements of government contracts include bonding, criminal background checks, and compliance issues. The corporation provides greater assurance of meeting the needs to the government.
- Death of a Shareholder – In this situation, the entity continues operating and the heirs or based on the documented wishes of the deceased determines the control over the company. In the interim, the company can continue to operate and conduct business.
An owner or controlling shareholder can control and manipulate the legacy (future history) of the business by exercising various tools to achieve the desired outcome. Other forms of entity existence do not have these tools available or must resort to other alternatives to achieve the same outcome. Incorporation makes conducting business a lot easier.
Separation of Family and Business
To me, this is one of the best reasons to incorporate. Many small businesses use the family to run the business. Incorporating makes it easier for the owner to separate the business from the family. He can remind the family members that the company owns the vehicles, the company controls the assets. The company owes the money for vendors and debts. This way, the family is protected from feeling obligated to provide financial assistance or provide personal guarantees for debt.
In addition, outsiders understand that the company is interacting with them and not a particular family member. Therefore, the outsider (vendor, bank, customer or government) communicates to the company via the company’s normal methods in day to day business. The family member is not obligated to the outsider.
Finally, the owner can control the ownership in small pieces over time to his family. He may elect to give a small piece of ownership through shares to his children or extended family. He can increase their percentage of ownership over time controlling their participation and or ensuring the ongoing operation of the business by retaining the best family members to continue the business upon his passing. The corporation can create a distinct line of ownership and control with proper share ownership and compensation. This way, the family members participating the most, receive more reward for their loyalty and perseverance.
There are other reasons to incorporate and these are more focused than above. For the purposes of the small business owner, the above provide the greatest substantiation for incorporating. Protecting the owner’s wealth is the most commonly cited reason as the corporation provides a shield to prevent access to his personal assets. Another good reason to incorporate is controlling the legacy of the company. This is important if the owner wants to expand and grow the company into a large operation. Finally, incorporation separates the family from the business. The separate entity demonstrates to outsiders that they are not interacting with a family but with a separate legal entity. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.