Browse Corporation

11.2.1 Advantages And Disadvantages Of Incorporation

Explore the advantages and disadvantages of incorporation in this comprehensive guide. Understand why incorporation as a legal entity might benefit or constrain your business.

In this section, we will explore the key advantages and disadvantages of incorporating a business. Understanding these aspects will help you make an informed decision about whether incorporation is the right choice for your business structure.

Advantages of Incorporation

1. Limited Liability

One of the primary advantages of incorporation is limited liability for shareholders. This means that the shareholders risk only the amount of money they have invested in the corporation’s common shares. For instance, if a shareholder has invested $1,000 in the corporation, they are not liable for additional contributions, even if the corporation goes bankrupt and its obligations exceed its assets.

2. Continuity of Existence

A corporation’s existence is not affected by the death of any or all its shareholders. Although its shareholders may change, the corporation will continue to exist until it is dissolved through legal processes such as bankruptcy. In contrast, a sole proprietorship ends when the owner dies, and a partnership may end with the death or withdrawal of a partner, unless otherwise specified in an agreement.

3. Transfer of Ownership

Shareholders of a public corporation can easily transfer their shares to other investors, enhancing the liquidity of the shares. This ease of transferring ownership is an attractive feature for investors.

4. Ability to Finance

Corporations can raise capital more efficiently by issuing various classes of shares and debt instruments. Limited liability encourages investors to provide capital with the potential for returns without assuming risk beyond their investment.

5. Growth Potential

Corporations are adept at handling large amounts of capital, enabling them to operate and expand large, growing businesses effectively.

6. Professional Management

Although shareholders own the corporation, they typically do not involve themselves in daily operations. Through their voting rights, shareholders elect a board of directors, who are responsible for managing the corporation’s affairs. If shareholders are dissatisfied with the board’s management, they can vote to elect new directors.

Disadvantages of Incorporation

1. Inflexibility

Corporations are subject to numerous statutory rules. Changes to the corporation’s charter and by-laws can be complex and may require formal approvals from governmental bodies, directors, and shareholders.

2. Double Taxation

A corporation’s profits are subjected to double taxation. First, corporate profits are taxed at the corporate level. When these after-tax profits are distributed as dividends to shareholders, the shareholders must also pay taxes on this dividend income.

3. Costly Setup and Annual Expenses

Incorporating a business incurs initial costs and requires ongoing annual expenses that are higher than those for sole proprietorships or partnerships. These include costs for annual returns, audits, preparation of federal and provincial corporate tax returns, and holding shareholders’ meetings. Compliance with securities laws may add to these expenses.

4. Capital Withdrawal

Statutory procedures must be strictly followed for the purchase and redemption of shares by the corporation, where it is permissible. However, minor investors in a public corporation can withdraw their capital by selling their shares on the market.

Key Takeaways

  • Incorporation provides limited liability, thus protecting the shareholders’ personal assets.
  • The existence and operation continuity of a corporation are not affected by changes in its shareholder structure.
  • Transferring ownership shares is relatively straightforward in a public corporation, enhancing share liquidity.
  • Corporations have a greater capacity to raise significant amounts of capital, facilitating growth and expansion.
  • Incorporation can lead to double taxation and involves higher initial and ongoing costs compared to other business structures.
  • Statutory procedures increase the complexity of making changes within a corporation, adding to administrative inflexibility.

Frequently Asked Questions (FAQs)

Q1: What does ’limited liability’ mean for shareholders?

A1: Limited liability means that shareholders are only liable for the amount of money they have invested in the corporation. They are not responsible for any debts the corporation incurs beyond their investment.

Q2: How does the continuity of existence benefit a corporation?

A2: The continuity of a corporation means that its operations can persist beyond the lives of its shareholders or executives, adding stability and longevity to the business operations.

Q3: How does incorporation facilitate greater access to financial resources?

A3: By issuing different classes of shares and debt instruments, corporations can attract investments from a broader range of investors, making it easier to raise large amounts of capital.

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## What is a significant financial advantage of incorporation? - [ ] No liability for shareholders - [ ] No need for raising capital - [x] Limited liability for shareholders - [ ] No costs for investors > **Explanation:** Shareholders are only liable for the amount they have invested in the corporation’s common shares, limiting their financial risk. ## How does the incorporation of a company contribute to its longevity? - [x] It is not affected by the death of shareholders - [ ] It ceases to exist when the shareholder dies - [ ] It terminates upon the death of a board member - [ ] It needs government intervention to continue > **Explanation:** A corporation's continued existence is not affected by the death of its shareholders, which ensures longevity. ## What is an advantage of the transferability of ownership in a corporation? - [ ] Restricted liquidity - [x] Ease of transferring shares - [ ] Ownership cannot change - [ ] Requires government approval > **Explanation:** Shareholders of a public corporation can transfer their shares to other investors with relative ease, enhancing liquidity. ## Why are corporations seen as a viable structure for financing? - [ ] Lack of interest from investors - [ ] Limited access to capital markets - [x] Easier issuance of different classes of shares and debt instruments - [ ] Difficulties in raising capital > **Explanation:** Corporations can raise capital more easily through the issuance of different classes of shares and debt instruments. ## How does professional management benefit a corporation? - [ ] Shareholders manage the corporation directly - [ ] Employees are the owners - [ ] No election of managers or directors - [x] Shareholders elect a board of directors to manage the corporation > **Explanation:** Shareholders elect a board of directors to manage corporate affairs, ensuring professional management compared to direct management by shareholders. ## What is a main disadvantage related to the incorporation statutes? - [ ] Flexibility of corporate policies - [x] Inflexibility due to statutory regulations - [ ] Lack of formal procedures for changes - [ ] Simplified approval processes > **Explanation:** Corporations are subject to many statutory rules which make changes to their charter and by-laws more complicated. ## How can the issue of double taxation be a disadvantage for a corporation? - [ ] Only shareholders pay tax - [ ] Corporate profits are not taxed - [x] Both corporate profits and dividends paid to shareholders are taxed - [ ] It eliminates taxes on dividends > **Explanation:** Double taxation occurs when the after-tax profits of a corporation are distributed as dividends to shareholders, who then pay tax on their dividend income. ## What creates additional financial burden for a corporation apart from the initial incorporation costs? - [ ] Free annual returns and audits - [ ] Preparation of personal tax returns - [x] Costs including annual returns, audits, and corporate tax returns - [ ] Lack of shareholder meetings > **Explanation:** In addition to initial costs, corporations incur annual costs for returns, audits, corporate tax returns, and shareholder meetings. ## How does capital withdrawal differ between corporations and other business forms? - [ ] Shareholders can withdraw capital anytime without restrictions - [ ] Capital withdrawal is simpler for corporations - [x] Corporations must follow statutory procedures for capital withdrawal - [ ] Corporations do not permit capital withdrawal > **Explanation:** Corporations must adhere to statutory procedures for the purchase and redemption of shares, but shareholders in public corporations can sell their shares to withdraw their capital. ## What structural aspect makes corporations well-suited for growth? - [ ] Restricted capital - [ ] Limited capital management capabilities - [ ] Inapplicable for large businesses - [x] Structured to easily handle large amounts of capital > **Explanation:** Corporations are designed to manage large amounts of capital, facilitating growth and the operation of large businesses.

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Tuesday, July 23, 2024