Disadvantages of the Corporation

• Corporations require annual meetings and require owners and directors to observe certain formalities.
• Corporations are more expensive to set up than partnerships and sole proprietorships.
• Corporations require annual fees and periodic filings with the state.

Michael Spadaccini has 14 years of experience as a corporate attorney specializing in business, trademark, securities and internet law. He has written several self-help legal guides, including Forming an LLC, Incorporate Your Business, The Operations Manual for Corporations and Small Claims Court Guidebook, all available from Entrepreneur Press.

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A small business may operate under various legal forms. The most common of these, particularly for new startups, is the sole proprietorship. The individual who owns the business receives all of its income and is responsible for all of the business's debts—including other liabilities to which the business may be subject (e.g. a customer slipping on that banana peel in the store). Under a sole proprietorship, the individual and the business are the same thing. If the business fails, the owner may have to sell his or her house and other goods to satisfy its debts. The principal advantage of incorporation is that the owner as a person is separated from the corporation, the latter viewed as an artificial "person." They are now two, not one. The corporation carries its own liabilities. When the corporation fails, the liability of its owners is limited to whatever they have invested—and no more. The business owner who started a business with $10,000 may lose the $10,000—but not the $300,000 he or she owns in other assets. The downside of incorporation is that the income of the corporation is taxed separately—and the owner gets his or her share only after the corporate tax has been deducted. The owner also then owes additional taxes on his or her earnings. Thus double taxation is involved. As a sole proprietor, the owner is taxed once but is personally exposed to all of the liabilities of the business. As a corporate entity, the owner is shielded from liabilities but is taxed twice. Is there a way to have the best of both worlds? Yes, there is. It is called the S Corporation.

The S corporation derives its name from Subchapter S of the Internal Revenue Code which provides corporations a "tax election" option—a choice on how they want to be taxed. Under Subchapter S, a company may elect to pass all of its profits to its shareholders directly. The shareholders are then responsible for paying taxes on this income stream. The corporation itself is not taxed. Meanwhile the limited liability benefits of the regular corporate form continue. Not all corporations, however, qualify for the Subchapter S tax election. The company may only have a maximum of 75 investors. They must all agree to this choice. All must be residents in the U.S. or U.S. citizens. The IRS also excludes certain types of companies described below. A regular corporation, called a C corporation, can convert itself to S status—and thus have it both ways.

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