What are the 5 Big Disadvantages of Incorporating a Business?

Are there disadvantages of incorporating? In the following article, we will explore the options you have as a business owner.

Owning and operating a business can be a complex endeavor.

Basic business building and maintenance activities are a lot to handle.

These activities include: 

  • product or service creation
  • sales
  • marketing
  • staff management
  • and more

Choosing a Business Structure

In addition, you as a potential business owner have to decide which type of legal structure is best for your type of business.

You may know that it’s common for business owners to form a separate corporate entity when starting a new business.

Is that always the best route to go? Should I incorporate? Let’s explore the subject of choosing a business structure more thoroughly.

What Are My Options?

As you work on forming your business, you will find that you have many different options. There are a lot of choices when choosing a business structure or entity.

Some key information is necessary to understand how each type of structure operates.

Here is a list of the four basic types of business structures.

1. Sole Proprietorship

When you choose to list your business as a Sole Proprietorship, you declare that you will be the sole owner and operator of that business.

Sole proprietors have complete legal responsibility for all debts and other legal action pertaining to the business.

If something goes wrong or a business debt is owed, you as the sole proprietor will be wholly responsible for resolving the issue.

All profits from a sole proprietorship are funneled through your personal tax return. As a result, any financial responsibilities or taxes due, rest on your shoulders alone.

An example of when a sole proprietorship would be a viable business structure is in the case of a freelance writer. This business owner works alone on writing projects for business clients.

This is the simplest and most cost-effective way to structure a business.

However, it’s not a sufficient structure for every type of business. It also carries with it a significant liability.

2. Partnership

Establishing a business with a Partnership structure is most common when two or more people join together. They work as a team to provide a service or product. Each partner shares in the financial responsibility, but also the profits. Learn about four different kinds of partnerships here.

A partnership is similar to a sole proprietorship with the exception being that there is more than one proprietor.

A common example of when a partnership structure would be a viable choice is if two friends wanted to open a small business. electrical repair company in which the two of them alone would handle the workload.

Liability belongs to all partners listed on the partnership agreement. It is a joint venture, both financially and legally.  As with a sole proprietorship, this structure also carries with it a significant liability.

3. Limited Liability Company

A limited liability company structure works similarly to a sole proprietorship or partnership. There are a few key differences though. With some exceptions, the owner(s) are not legally responsible for the business’s financial obligations.

For example, an LLC owner who is facing a lawsuit will not be responsible for the financial implications. Unless they have personally guaranteed the debt or they have ignored the corporate formalities necessary to treat the LLC as a separate business entity.

If corporate formalities are ignored or the members of an LLC abuse their rights, the court may pierce the corporate veil. Piercing the corporate veil is the term used to refer to holding members of an LLC personally liable. This would apply to any debts or lawsuits affecting an LLC.

The LLC structure provides some legal protection for business owners. It helps shield personal assets from being affected by a business failure. The benefits of an LLC make it a popular choice of business structure. An LLC is easily formed, maintenance is simple, and it limits owners’ liabilities. The LLC has become the most common business structure for small businesses in Arizona.

4. Corporation

The Corporation is a business structure often chosen by larger businesses. The legal definition of a corporation is that it is a group of people authorized to act as a single entity and recognized as such in law.  Larger businesses use this business structure more often. There is greater flexibility afforded by the division of ownership into stock. Owners of that stock are referred to as “shareholders”.

There are different types of corporations. The general overview is roughly the same for all incorporated businesses though. Being an incorporated business means that:

  • The officers’ personal assets are protected from a business failure;
  • Management of the business is divided between officers, typically appointed by a vote of the shareholders;
  • Shareholders’ power is often determined by the “class” of stock the shareholder owns;
  • Corporations can continue indefinitely by changing board members, directors, etc.

Incorporation: The Pros and Cons

There are some great benefits to incorporating your business besides the benefits listed above. Incorporating your business means that you have a legal right to sell shares of stock in your company.

You can also run your business somewhat anonymously if you aren’t eager to be public about your involvement with the business.

Yet, there are some disadvantages of incorporating as well.

Here are a few things you may want to consider before you make the decision to incorporate your business:

Incorporating Can Be Costly

It costs more money to establish and maintain a corporation than it does a sole proprietorship, LLC, or other business structure. According to smallbiztrends.com, there are ~$400 of fees associated with incorporating in Arizona. That doesn’t include attorney fees, which can be quite costly as well.

It will be important for you to check the amount of capital you have available to form your business.

Incorporating can be financially overwhelming for small businesses or those with little capital.

Establishing a Corporation Involves Much Time and Paperwork

There are many legal documents that need to be filed if you choose to incorporate your business.

Those legal documents include but are not limited to:

  • Articles of Incorporation
  • Company Bylaws
  • Certificates of good standing
  • Non-disclosure agreements
  • And more.

Many business owners find incorporating quite labor intensive. There are a large number of forms, paperwork, and research needed to incorporate.

Corporations are Subject to Stringent Compliance Regulations

Corporations are monitored by the government and subject to the strict laws imposed on corporations.

They must be willing to prove that they meet all required regulations.

They also must complete all required legal documents to remain in compliance.

The legal documents required for sole proprietorships, partnerships, and even LLCs aren’t as time-consuming. There are many more for establishing and maintaining a corporation, and they take a fair amount of time.

Incorporating Your Business Can Mean Double Taxation for You

One of the most prominent disadvantages of incorporation is that company profits are often double taxed.

Corporations are taxed first on their net taxable income. Then business owners are also taxed on any salary or dividends they receive.

Therefore, a larger business income and profit are often required to make up for the double taxation on the business profits.

A Business Failure Can Have a Greater Loss Impact

When you are running a sole proprietorship failures hit hard. If the business fails, the primary impact will fall on you and you alone.

However, when you are running a corporation the ripple effect of a business failure is much more significant.

You (and your fellow shareholders) run the risk of losing money via loss or elimination of stock values. You likely have employees that will lose their jobs and a major source of income for themselves and their families as well.

Also, if there is significant debt attributed to your corporation you may face costly legal battles as you work to dissolve the corporation. You’ll have to ensure you do this in a manner where your creditors get paid.

The Bottom Line: Should I Incorporate My Business?

As you can see, there are many factors to consider before you take the steps to incorporate your business.

Fowler St. Clair works closely with businesses of all sizes in their corporate and business law matters. Our team of expert experienced attorneys focus on a limited suite of practice areas that include Real Estate, Business LawCivil Litigation, and Estate Planning.

By keeping our focus limited to what we do best, we can provide you with the information and support you need to help make your business the best it can be.

We can meet with you to assist you in deciding which type of business structure is best for your business. And we can work with you to create the required documentation needed.

This will help ensure you have all the necessary procedures covered from a legal standpoint.

Having the correct legal documents in place for your business is a vital step for any successful business venture.

Contact our team of experienced business law attorneys today to find out if incorporation is the best choice for your business.