In What Circumstances Is Incorporation Relevant, And When Should It Not Be Undertaken - Essay Example

Company life: To incorporate or not to incorporate.  In what circumstances is incorporation relevant, and when should it not be undertaken?       Introduction  The decision to incorporate a company arises when there are benefits arising out of incorporation in relation to other forms of ownership, proprietorship, partnership, etc.  If the benefits are not commensurate with the investments and the efforts involved, it may need a re-look.   The subject has been revisited by many analysts and scholars who have espoused the cause of incorporation.    Broadly speaking the decision regarding incorporation is governed by the Purpose of the enterprise, Growth potential of the business, need for Professional management, Tax planning, Notional values in the eyes of the public, advantages & disadvantages and Identity phenomenon, etc.  The discussions about the advantages and disadvantages of incorporation would be very meaningful with background analysis of the other factors governing incorporation.   Factors governing incorporation of a company The World Bank has launched a new online discussion on ‘Business Registration.’  …  ‘Over the past two years many OECD countries have greatly improved their regulatory burdens with regards to business incorporation.’  (World Bank Private Sector Development Blog, 2010).  Needless to say, the importance of incorporation and the need for minimizing the burden of red tape culture in this respect, for the encouragement of private sector has been recognized throughout the world.   However, its utility to a particular business enterprise is governed by the factors referred above. Purpose of the enterprise   The size of the venture, nature of the business and the purpose of the enterprise are the important factors in deciding the suitable form of ownership.  For example, in the case of a venture capital company, where the risk element is inherent in the business, the promoters would like to go for incorporation for the obvious reasons.  The investors with the risk taking ability and propensity to speculate would invest in the venture capital business, taking chance with regard to the viability of the project, where the risk reward ratio is very high. For big projects with long gestation periods, from the angle of capital formation, credit facilities, employee strength, etc. incorporation of the business is necessary. Raising funds through initial public offerings of stock is easier for the big projects. Now fundraising is the world phenomenon with an array of instruments such a Global Depository Receipts (GDR), American Depository Receipts (ADR), etc. Growth potential of the business  In the growing companies, the profit is ploughed back into the business.  Since the profit is not distributed by way of dividends, the question of taxation in the hands of shareholders does not arise.  Therefore long term capital appreciation is the feature of the growth oriented companies,   and the continuity is ensured in view of the long term nature by incorporation, in addition to tax planning. Professional management  In the modern business environment, technology plays an important role, and the technology provider invariably wants to have a say in the management.  The era of family business is behind us, and the management is entrusted to the professionals.   Under these circumstances, incorporation is the ideal route for establishing and running the business.    Notional value    The tags such as Inc., Ltd., Corp (legal ending in the corporate name) meaning Incorporated, Limited and Corporation respectively, in itself are the important factors, because it is perceived as ‘value’ to the company.  Here, It is the perception, rather than the advantages or disadvantages that are considered important.  The promoters may like to have their company incorporated based on intangible values, and not purely in terms of monetary considerations.  For example, a new venture started by a reputed business family would like to have their venture incorporated, since they may not be interested to start the venture on proprietorship basis.       Advantages and disadvantages There are advantages and disadvantages of incorporation over other forms of ownership, and these could be analyzed with reference to the following:   1. Advantages and disadvantages inherent in the ownership structure on formation of a company.      2. The advantages and disadvantages arising out of the treatment given to the companies as per the Company Law.  This distinction in the analysis is important from the view of reforms that may be required in Company Laws.   It is also a pertinent issue from the financial accounting point of view, especially with regard to taxation.  Relevance of incorporation is dictated by the net effects of the advantages and disadvantages of incorporation in relation to other forms of ownership such as proprietorship, partnership, etc. after taking into account various factors governing incorporation of a company.  These factors discussed above plays an important role in decision making along with the advantages and disadvantages measured in terms monetary values. Some of the points like taxation may be overlapping on account of financial and accounting implications. Nevertheless to say, an existing company would like to work out the impact of these benefits and drawbacks and take a final decision at an appropriate time.  This is because of the fact that the business is already functioning, in whatever form hither to it was existing.  According to the management these monetary aspects may not be critical compared to the other factors, and the incorporation decision would be taken, in the interest of the business, when the time is ripe, i.e. when it is in expansion or diversification mode.             Inherent Advantages Limited liability: This is one of the most important advantages of forming a corporation. Limited liability means that the shareholders are liable to the extent of the value of the shares held by them and their personal property is not attached in case of any loss to the corporation. Thus, this advantage provides a security to the shareholders and promotes and induces them to invest more in the company. Transferable ownership:  Ownership in a corporation or LLC is easily transferable to others, either in whole or in part. Some states laws are particularly attractive in this respect to encourage capital formation for the development of the industry as a whole. Perpetual existence:  A corporation is capable of continuing indefinitely. Its existence is not affected by the death of shareholders, directors, or officers of the corporation. Credit rating: Regardless of an owners personal credit status, corporations could be rated separately.  Corporate credit facilities area superior in nature. Banks and financial institutions view corporate companies favorably in extending credit facilities.  In fact the policies of these agencies are favorable for the companies to deal with.            Advantages in terms of Law  Personal assets: Corporations and Limited Liability Companies (LLCs) may hold personal assets like residential quarters, cars, etc. In the even of a lawsuit or bankruptcy, these assets may be protected. A creditor of the owner of a corporation or LLC cannot seize the assets of the company, though they can seize their ownership shares in the corporation. Taxation: In the United States, corporations are taxed at a lower rate than individuals. Also, they can own shares in other corporations and receive corporate dividends 80% tax-free. There are no limits on the amount of losses a corporation may carry forward to subsequent tax years. Retirement funds: Retirement funds and qualified retirements plans, such as a 401(k), may be established more easily. However, it should be remembered that, if the privileges accorded to the corporate company are found to be misused, the courts can pierce the corporate veil.   When a corporation is a sham, engages in fraud or other wrongful acts, or is used solely for the personal benefit of its directors, officers, or shareholders, courts may disregard the separate corporate existence and impose personal liability on the directors, officers, or shareholders. In other words, courts may pierce the "veil" that the law uses to divide the corporation (and its liabilities and assets) from the people behind the corporation. (The free dictionary by Farlex)       Disadvantages of incorporation Registration process in some countries is time consuming and tedious.  The cost of incorporation may be prohibitive for small businesses as it involves paper work, filing, fees payable (varies from state to state)  and the charges of attorneys. Taxation in the hands of the shareholders:   Although being incorporated may offer some tax advantages and extra deductions such as health insurance premiums, it us also exposed to double taxation. The share holders are required to pay tax on the dividends received from the company.  Therefore, for a company which distributes all its earnings, without any plough back into the business, to the shareholders by way of dividends, it is a disadvantage.   Housekeeping:  It has implications in financial accounting on account its structure and the requirements in law, which involves records maintenance, reporting and accounting; consequently, increase in man power for this purpose.  If there is no sale of stock to the public, procedures with regard to records maintenance and reporting is simple.  Otherwise, compliance with the legal formalities is an important administrative issue. Identity phenomenon Identity in human life is an important issue.  All human beings including the companies strive for identity which is good, respectable and reputed.  The status of the corporate company in the eyes of the public has undergone significantly on account of changes and developments in corporate governance, corporate culture and corporate social responsibility.  Therefore, forward looking companies with a long term view and desire for continuity into future generations would like to join the elite club of corporate Companies. Corporate governance: The governments of the developed countries, confederations of industries and professional bodies issue corporate governance guidelines and codes of best practices.  The Cadbury report, 1992 in UK acts as a reference guide for stock markets.  The report of the Ribbon committee (US, 1998) recommends measures for improvements in corporate governance.  The OECD Principles 1999 and 2004 indicates the criticality of the issue in the global level.  Corporate culture: It is the personality of the organization and signals to the stakeholders and public ‘how things are done around here’ meaning precisely, the Culture of the entity. Corporate social responsibility:  It is a concept, that organizations have an obligation to consider the interests of the employees, customers, suppliers, community and environment in all aspects of their business.  Enterprises are expected to make decisions not purely on financial considerations.  They should have long term social and environmental responsibility keeping in mind the future generations, and volunteer to espouse the social causes. Corporate citizenship: It refers to the behavior of the businesses in meeting their legal, ethical and voluntary responsibilities placed on them by the stakeholders and statute. Therefore, it goes without saying that at the minimum level, the corporate companies meet their responsibilities as per law which provides for safety, security, fairness and honesty towards the stakeholders through so many laws in relation to employment, business, etc., leaving alone the voluntary initiatives. The companies are also benefited greatly in this process, by enhanced brand image and reputation, customer loyalty, increased productivity, increased financial performance and ability to attract and retain employees, when they discharge their responsibilities effectively.           References World Bank Private Sector Development Blog, 2010, The importance of facilitating business registration: growth!, viewed 9April 2010, http://psdblog.worldbank.org/psdblog/2005/06/the_importance_.html Benefits of incorporation, viewed 9April, http://www.omniglot.com/onlineinfo/bost/benefits-of-incorporation.html  Reference for Business - Encyclopedia of Business, 2nd ed,  Incorporation, viewed 9April, http://www.referenceforbusiness.com/small/Inc-Mail/Incorporation.html The free dictionary by Farlex, Piercing the Corporate Veil, viewed 9April, http://legal-dictionary.thefreedictionary.com/Lifting+the+corporate+veil   Read More