The good news is you are reading this because you have given serious thought to the legal form of your business. The law offers multiple entity options through which you can operate your business, and choosing the right one now will help you avoid a disruptive and costly conversion in the future.
The bad news is that the classic corporation is no longer a good choice for many entrepreneurs. Having delivered the good news and bad news, below we go through a review of the top disadvantages of incorporating a business and why it is not a good choice for most small business owners.
But First . . . The Advantages of Corporations
Corporations are not completely outdated, and the law behind their creation and continued existence offers extremely valuable benefits to business owners. Two of those foundational reasons remain relevant today. First, corporations offer limited liability protection to their owners. Simply put, your personal assets are protected from the activities of the corporation. Second, corporations offer an easy way to raise capital and encourage investment. Through the sale of stock, a corporation can raise capital and bring in new owners. However, these two benefits are now available through other business models.
And Now . . . The Disadvantages of Corporations
Below, we list in order of importance the most significant disadvantages of incorporating and show that more modern alternatives can competently fill the gap.
#1: Business Fit
Corporations are best for big enterprises; they don’t fit well with start-ups. Corporate governance structure, ownership mechanics, tax filing requirements, internal record keeping, and general operation methods lend themselves more easily to large commercial enterprises. The corporate form is ideal for a diverse commercial enterprise with layered management and a large payroll. In the alternative, most start-up businesses have a single commercial enterprise, one or two managers, and a few employees. Structuring your start-up business as a corporation is a mismatch that has no real benefit. There are many alternative business entity options that can better fit your needs.
#2: Taxation
A corporation is its own person. As such, it must pay its own taxes. The practical effect is the corporation will pay taxes on its income, and then you, as its owner, will pay taxes on your income. This is commonly known as the “double tax” disadvantage.
In some cases, a corporation can avoid double taxation by making an S corporation election, but this election is not always available (for instance, when the owners include business entities or foreign individuals). Alternatively, double taxation is easily avoided by other totally appropriate and viable business entity structures. Further, because a corporation is its own person, an additional set of tax returns must be prepared and filed. Alternative business entities offer pass-through tax treatment and bypass a separate business tax return.
#3: Governance
Corporations have a classic and multilayered governance structure consisting of shareholders, a board of directors, officers, and employees of varying seniority. As mentioned at the beginning, this type of structure fits quite well with large business enterprises. However, with startups, and even medium-sized businesses, operating through these layers can be clunky and inefficient. Adopting a corporate governance structure as a small business means that you have to fill these posts even if you don’t need to. On the other hand, alternative business entities provide a more intuitive and better attuned governance structure.
#4: Internal Procedures and Recordkeeping
The law expects corporations to follow certain internal procedures and keep accurate records. Failure to do so could jeopardize the integrity of the corporate entity and specifically its limited liability protection. Standard procedures demand specific notice provisions for corporate meetings, recording of those meetings, the drafting of resolutions, and the maintenance of shareholder records and a stock ledger. While all business entities need to respect internal controls and maintain accurate records, most of a corporation’s requirements are unnecessary for small businesses. Other business entity options provide a trimmed down version of required procedures and recordkeeping that makes more sense.
#5: Stock and Shareholder Issues
Standard corporate governance documents rarely provide restrictions on stock transfers. Indeed, the unrestricted sale of stock is natural to the original purpose of a corporation, and in large companies this makes little difference. However, in a small business, the unrestricted sale of stock can be disastrous. Therefore, small businesses that incorporate must draft and adopt a shareholder agreement in addition to having bylaws. This additional undertaking is expensive and time consuming. It is also unnecessary because other business entity options have ownership interest restrictions built into their governing documents (i.e., in a standard limited liability company operating agreement).
#6: Wind Down of Business
Most corporations, or the state statutes that govern them, provide for specific procedures to wind down business affairs. These procedures can be clunky and unnecessary for most smaller businesses. States recognize this, and with other business entity options the internal governance documents or state statutes provide for more appropriate wind-down requirements.
#7: Expenses and Compliance
Corporations generally have more government administrative expenses and compliance requirements compared to other business entities. They also need outside professional services more often, such as a certified public accountant to prepare corporate tax returns. Other business entity forms can largely avoid these expense and compliance requirements.
Conclusion
Modern business law offers good and sophisticated alternative business entity options, such as limited liability companies. Those options still provide the best of a corporation—its limited liability and investment mechanisms—while also delivering a more streamlined platform that can service your small business. Finally, these business entity alternatives are able to grow as your business grows and therefore can operate as the permanent foundation upon which your enterprise is launched and develops into the future.
BrewerLong Can Design Your Perfect Business Entity
BrewerLong’s attorneys have decades of experience guiding small businesses towards a path of success. We understand the disadvantages of corporations and how business growth needs are based on your line of commerce. Therefore, we can help you design a business platform that will meet your needs for years to come. Contact us today.
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