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Incorporation is the process of turning a business into a corporation by filing articles of incorporation within your state of operation. Relative to other small-business structures, a corporation has important legal protections, but also some increased paperwork requirements and tax disadvantages.
Separation of Business Obligations
A primary reason small-business operators incorporate is to legally separate their companies from the individual owners. Typically, the legal and financial obligations of the corporation or treated as separate from the owners' personal obligations. If the corporation is sued for negligence or discrimination, for instance, individual owners aren't normally accountable for paying any settlements or damages. However, your financial damages suffered by the company may adversely affect your ability to receive dividends or profit from share price appreciation.
Ownership and Financing Opportunities
Incorporation also allows a company to raise equity by issuing shares of stock. Relative to bringing in new money through debt financing, equity investment has a few key benefits. First, you don't have to repay equity investment. Investors earn money when the corporation succeeds and distributes earnings. Investments also don't hamstring your future cash flow like high debt leverage does. From an ownership perspective, it is also easier to sell or transfer shares of a corporation than ownership in proprietorships or partnerships, according to Entrepreneur. You can transfer shares to other family members or sell them for profit to other investors.
Complex Reporting Requirements
If you despise paperwork and formal requirements, incorporating may lead to some frustration. The process of preparing and filing articles of incorporation takes time and involves payment of state-based registration fees. Corporations are required to maintain a board of directors and to hold annual shareholder meetings. You also are required to periodically file financial documents and other reports with the state. Publicly-traded corporations must report earnings each quarter and year as well.
Increased Tax Burden
Another negative effect of incorporation is that the Internal Revenue Service has a chance to generate more tax revenue from you and the business. Corporations face what is commonly referred to as double taxation. The business pays taxes on its annual earnings. Individual shareholders also must pay taxes in money they earn from the company. Investor earnings include dividend payments from the corporation and capital gains on the sale of stock.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.