There are various forms of company ownership, namely, sole proprietorship, partnership, corporation and co-operative. The most common form adopted by large companies is a corporation. This form of ownership has a number of features which puts it at an advantage over others and hence accounts for its popularity. The most important feature is that of limited liability which will be discussed in detail further on in this article. However, as we all know too well, these advantages come along with a fair share of disadvantages of a corporation.
A corporation is a separate legal entity, separate from its owners, which is entitled to a set of rights and responsibilities, much the same as those given to an individual. This implies that corporations are entitled to the right to enter into contracts, borrow funds, sue, pay taxes etc. The management is separate from the owners in that the owners are shareholders who elect the Board of Directors. This board is responsible for the smooth functioning of the company and are paid a fixed annual salary while shareholders in the company are equal partakers in profits and losses of the company. The feature of limited liability as mentioned above means that shareholders may enjoy profits of the company but are not held liable for any debt that has to be paid to the creditors of the company. This makes it a highly favourable form of enterprise for company owners.
Despite being a popular form of ownership, there a few disadvantages of a corporation which need to be considered before forming an opinion about it. The disadvantages of a corporation are four-fold as explained below:
The most pressing concern with an incorporated setup is that of double taxation. Since a corporation is a separate legal entity, it is subject to corporate tax on its earnings. These are subjected on the corporation itself. Further, when the company distributes its net profits among its shareholders in the form of dividends, these dividends are then included in the taxable income of the shareholders and are subjected to income tax. Thus, taxes are imposed at two levels reducing the net level of profits garnered through the company.
A critic may argue that taxes are imposed at two different levels on two different entities, so each party only ends up paying tax once. But the truth is that a trickle-down effect is observed here. Since the shareholders are part owners of the company depending on the number of shares owned by them, a tax on the company reduces the net profits of the company and a further distribution of these profits in the form of dividends has the effect described above. Hence, the shareholders receive profits which have been ‘net’ted twice, and the final gain obtained is considerably reduced considering the high rates of corporate tax in most countries. For example, in the US, the rate structure produces a 34% tax rate on incomes from $335,000 to $10 million which increases to a rate of 35% on incomes above $18,333,333 as of 2011.
Another one of the disadvantages of a corporation is that it involves a number of administrative routines and other formalities which may not be present in a partnership or proprietorship. In the US, in order to incorporate a business, an application with the Securities and Exchange Board has to be filed after which the company is subject to a number of regulations associated with it. Each State has a different set of rules which have to be followed in order to incorporate a company within that State. After its incorporation in one State, the company can only function in another State as a “foreign corporation”. Further, different types of corporations have different sub-sections under which they have to be registered.
These rules may vary depending on the jurisdiction under which the corporation falls. Hence, it is evident that a number of administrative issues may arise due to the complex nature of corporations.
Separate Ownership and Management
This is a very important factor that may not be evident at first glance, but as has been expedited by noted economists such as Adam Smith. Since the management of a corporation is separate from its ownership, they former may not have as much of an interest in the financial health of the company as the owners would. As mentioned before, the Board of Directors usually receive a fixed annual salary which may or may not be accompanied by a stake in the company. If that is the case then there will not be any direct benefits for the management if the company performs well. This very point is brought out by Adam Smith in his book Wealth of Nations, where he says that the interests of the owners (shareholders) may not be looked after by the management in such a setup.
This is an important moral issue that needs to be addressed before embarking on the incorporation of a company.
Expensive to Form
Corporations are expensive to form when compared to other forms of company incorporations. This is because of various filing fees which are associated with their formation.
Though this feature is usually accepted as one of the benefits of a corporation, it could work out to be a drawback as well. Since the owners of the company (stakeholders), are not liable to pay back the debts of the company in case of a bankruptcy situation, it may be difficult for the corporation as an entity to obtain funding from creditors in situations when the corporation is not performing well. Lenders will be wary of this feature of limited liability since the accountability of the company lies on shaky ground.
The importance of funding for any company cannot be stressed on enough, and if this primary feature of a corporation presents a roadblock to obtaining funding, then it is safe to say that it is one of the primary disadvantages of a corporation.
Summing it all up …
These are a few of the significant disadvantages of a corporation. However, it cannot be argued that almost all large companies are incorporated. It is an important form of ownership which has been in existence since the nineteenth century. A number of factors such as performance expectations, liquidity, solvency and business condition need to be taken into account before deciding whether or not to incorporate your business. In conclusion, it can be said that despite the disadvantages of a corporation, its positive points have been sufficient to pull it through as a bankable form of business ownership.