As you have seen, the liability question is at the heart of all businesses. From starting up to selling out, business owners are well aware of the risks they take all the time, and they do their best to minimize the risks they can control. In an attempt to encourage businesses to take risks, business laws in all 50 states allow businesses to form as corporations.
Corporations are much different from sole proprietorships and partnerships. They are distinct legal entities. The corporation has an existence separate and apart from its shareholders, directors, and management. The law respects this separate existence in a wide array of circumstances, including liability protection. For the most part, someone making a claim against a corporation can only collect from the corporation's own assets; the personal assets of the shareholders are not at risk.
Obviously, this is a huge benefit. It allows corporations to take risks that sole proprietorships and partnerships cannot, because the worst-case scenario for corporations is less devastating to the business owners than for sole proprietorships and partnerships. Many businesses of all sizes, from the smallest one-person operation to the largest publicly traded companies, choose the corporate model.
However, with the benefits of having a corporation come some additional responsibilities. You cannot simply create a corporation by yourself. Instead, you have to file paperwork with whatever state governmental agency is responsible for establishing corporations, which is usually the secretary of state. There is a fee for creating and maintaining a corporation, and you must make certain reports and filings on a regular basis in order to keep the corporation current.
More importantly, since, as a business owner, you want others to respect the separate existence of the corporation, you also must respect its separate existence. For example, you should name a board of directors and officers of the corporation. You should have annual meetings and write out minutes of those meetings. The corporation should have its own bank accounts, and under no circumstances should you deposit corporate funds into a personal bank account. The danger is that if you don't respect the formalities of running a corporation, then you may lose the ability to keep creditors from collecting from your personal assets.
Some corporations also have a significant tax disadvantage. Tax law tends to respect the separate existence of the corporation by imposing a corporate tax on its profits. Because these profits are taxed again when the corporation pays out dividends to its owners, a layer of double taxation results from the corporate form. Corporations with a small number of owners may be eligible to elect to be treated as an S corporation, referring to the part of the Internal Revenue Code (subchapter S) that defines this particular type of corporation. Although the rules are complicated, the net effect of being an S corporation is that one largely avoids the double taxation that regular corporations (called C corporations, after a different part of the Internal Revenue Code) must face. Work with your tax advisor to determine whether an S corporation is a good option for your business.
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Fool contributor Dan Caplinger welcomes your comments.