Corporations Compared to Sole Proprietorships and Partnerships

The most important advantages - and disadvantages - of corporations over partnerships and sole proprietorships.

Corporations enjoy many advantages over partnerships and sole proprietorships. But there are also disadvantages. We cover the most important ones below.

Advantages:

Stockholders are not liable for corporate debts. This is the most important attribute of a corporation. In a sole proprietorship and partnership, the owners are personally responsible for the debts of the business. If the assets of the sole proprietorship or partnership cannot satisfy the debt, creditors can go after each owner's personal bank account, house, etc. to make up the difference. On the other hand, if a corporation runs out of funds, its owners are usually not liable.

Please note that under certain circumstances, an individual stockholder may be liable for corporate debts. This is sometimes referred to as "piercing the corporate veil." Some of these circumstances include:

  • If a stockholder personally guarantees a debt.
  • If personal funds are intermingled with corporate funds.
  • If a corporation fails to have director and shareholder meetings.
  • If the corporation has minimal capitalization or minimal insurance.
  • If the corporation fails to pay state taxes or otherwise violates state law (like defrauding customers).

Self-Employment Tax Savings. Earnings from a sole proprietorship are subject to self-employment taxes, which are currently a combined 15.3% on the first $97,500 of income for tax year 2007. With a corporation, only salaries (and not profits) are subject to such taxes. This can save you thousands of dollars per year.

For example, if a sole proprietorship earns $80,000, a 15.3% tax would have to be paid on the entire $80,000. Assume that a corporation also earns $80,000, but $40,000 of that amount is paid in salary, and $40,000 is deemed as profit. In this case, the self-employment tax would not be paid on the $40,000 profit. This saves you over $5,000 per year. Please note, however, that you should pay yourself a reasonable salary.

Continuous life. The life of a corporation, unlike that of a partnership or sole proprietorship, does not expire upon the death of its stockholders, directors or officers.

Easier to raise money. An corporation has many avenues to raise capital. It can sell shares of stock, and it can create new types of stock, such as preferred stock, with different voting or profit characteristics. Plus, investors be assured that they are not personally liable for corporate debts.

Ease of transfer. Ownership interests in a corporation may be sold to third parties without disturbing the continued operation of the business. The business of a sole proprietorship or partnership, on the other hand, cannot be sold whole; instead, each of its assets, licenses and permits must be individually transferred, and new bank accounts and tax identification numbers are required.

Disadvantages

Higher cost. Corporations cost more to set up and run than a sole proprietorship or partnership. For example, there are the initial formation fees, filing fees and annual state fees. These costs are partially offset by lower insurance costs.

Formal organization and corporate formalities. A corporation can only be created by filing legal documents with the state. In addition, a corporation must adhere to technical formalities. These include holding director and shareholder meetings, recording minutes, having the board of directors approve major business transactions and corporate record-keeping. If these formalities are not kept, the stockholders risk losing their personal liability protection. While keeping corporate formalities is not difficult, it can be time-consuming. On the other hand, a sole proprietorship or partnership can commence and operate without any formal organizing or operating procedures - not even a handwritten agreement.

Unemployment tax. A stockholder-employee of a corporation is required to pay unemployment insurance taxes on his or her salary, whereas a sole proprietor or partner is not. Currently, the federal unemployment tax is 6.2% of the first $7,000 of wages paid, with a maximum of $434 per employee.

If you pay any required state unemployment tax, you can receive an offset credit of 5.4%, effectively lowering the federal rate to 0.8%, for a maximum of $56.00 per employee per year.

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