Disadvantages of Incorporation and Introduction
A company refers to a group of individuals who are associated together to attain a common goal. A company incorporated under the Companies Act of 2013 or any other company law is legally defined as a company. There are certain advantages and disadvantages of incorporation. Incorporating a company can create a separate legal entity for itself, have perpetual succession, provide power to own particular property, create the capacity to sue, and have easier access to capital. However, it also has some significant disadvantages.
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The image shows the paperwork on the incorporation of a company. The disadvantages to incorporation are further explained in the details below.
Introduction to Incorporation
Incorporation is the legal process of formation of a new corporation of any kind such as a business, sports club, cafe, nonprofit organization, etc. Incorporation becomes an independent legal entity that is recognized by law. These companies can be identified on their behalf by terms such as "Inc" and "Limited". It will be a legal entity completely separated from the owner.
Steps in Incorporation of a Company
Determining the availability of names
Drafting Articles of Incorporation and Articles of Incorporation
Prints, signatures, stamps, memorandums and article reviews
Power of Attorney
Documents to be Filed with the Registrar of Companies
Statutory Declaration in e-Form
Payment of Registration Fees
Certificate of Incorporation
Disadvantages of Incorporation
Formalities and Expenses
Starting a business is a very complex and long legal process that requires a great deal of time and money. These sophisticated procedures discourage people who are seriously and passionately uninterested in doing business. Even after the establishment of the company, it must be very tightly controlled and must follow the statutory provisions of the Companies Act. Certain special events or activities such as accounting, company audits, meetings, borrowing, lending, investment, and capital issuance, dividends, etc. must be carried out and performed strictly in accordance with the Companies Act.
Other companies do not have to follow as many rules and regulations as they do.
Corporate Disclosures
Despite the large legal framework designed to ensure maximum transparency and disclosure of company information, not all the information is available to the company employees and others in the management. Everyone has limited access to the company’s information.
Separation of Control from ownership
Shareholders of a company who are in minority do not really have control of the functions and decisions of the company.
This is because the number of employees in a company is so large that even individuals or a small number of people cannot make a significant impact on the work of the organization.
Therefore, the position labeled "ownership" is just a term that has no real meaning. You have no active or complete control over the activities of the company.
Payment of Heavier Taxes in Some Cases
Compared to other forms of companies, incorporations have to pay higher taxes as they do not receive discounts or minimum tax limits.
They are also required to pay income tax at a fixed rate on all income, while other legal entities are taxed in stages or at a fixed rate.
Therefore, many companies often start as private or partnership companies. And as the scale grows, it becomes an incorporated company.
Social Responsibility
Many companies have billions of dollars in assets and employ hundreds of thousands of people. They have a significant impact on society, and these companies often participate in social activities that are part of their corporate social responsibility (CSR) campaigns. These incorporation companies are so influential that they must adhere to certain social norms and contribute to the development of society.
FAQs on Drawbacks of Incorporation Explained
1. What are the main drawbacks of incorporating a company as per the CBSE syllabus for the 2025-26 session?
Incorporating a company, while offering benefits like limited liability, comes with several significant drawbacks. The primary disadvantages that students should understand are:
- Complexity in Formation: The incorporation process is lengthy, complex, and requires fulfilling numerous legal formalities as prescribed by the Companies Act, 2013.
- High Cost: Formation is an expensive affair involving fees for preparing documents, registration, and professional services.
- Double Taxation: The company's profits are taxed, and when these profits are distributed as dividends to shareholders, they are taxed again as personal income.
- Excessive Regulation: Incorporated companies face strict regulatory compliance, including mandatory audits, filing annual reports, and holding statutory meetings.
- Separation of Ownership and Control: There can be a conflict of interest between the shareholders (owners) and the management (controllers) who run the company.
- Delay in Decision Making: The hierarchical structure and need for board approvals can lead to significant delays in making crucial business decisions.
2. What is the basic difference between 'incorporation' and a 'corporation'?
The terms 'incorporation' and 'corporation' are related but distinct. Incorporation is the legal process or action of creating a new business entity that is legally separate from its owners. This involves drafting documents and registering with the government. A corporation, on the other hand, is the outcome of that process—it is the business entity or company itself, which has its own rights and obligations.
3. Why is 'double taxation' considered a major financial disadvantage of incorporation?
Double taxation is a significant drawback because the company's income is taxed at two different stages. First, the corporation pays a corporate income tax on its net profits. Second, when the remaining profits are distributed to the shareholders in the form of dividends, the shareholders must pay personal income tax on that dividend income. This effectively reduces the net earnings received by the owners compared to other business structures like sole proprietorships where profits are only taxed once.
4. How does the separation of ownership and control become a potential drawback in an incorporated company?
In a corporation, the shareholders are the true owners, but they delegate the responsibility of running the business to a Board of Directors and professional managers. This separation can become a drawback when the interests of the management do not align with the interests of the owners. For example, management might prioritise high salaries, lavish expenses, or short-term goals, while shareholders might prefer long-term growth and higher dividends. This potential conflict of interest can harm the company's overall health and profitability.
5. What are some examples of the extensive legal formalities that make incorporating a company complex?
The complexity of incorporation arises from the numerous legal requirements under the Companies Act, 2013. Some key examples include:
- Preparing and filing foundational documents like the Memorandum of Association (MoA) and Articles of Association (AoA).
- Obtaining a Director Identification Number (DIN) for all proposed directors.
- Paying stamp duty and registration fees to the Registrar of Companies (RoC).
- Holding statutory meetings like the Annual General Meeting (AGM).
- Maintaining statutory registers, such as the register of members and register of directors.
- Conducting a mandatory annual audit of financial accounts.
- Filing annual returns and financial statements with the RoC regularly.
6. In what way is lifting the 'corporate veil' a disadvantage for the members of a company?
Normally, a company is a separate legal entity, and its members have limited liability. This legal separation is called the 'corporate veil'. However, in certain situations, such as fraud or improper conduct, the court can lift this veil and hold the members or directors personally liable for the company's debts and actions. This possibility acts as a drawback because it negates the primary advantage of limited liability, exposing the personal assets of the individuals behind the company to business risks.
7. How does the formal winding-up process pose a disadvantage for a corporation?
Unlike a sole proprietorship, which can be closed easily, a corporation must undergo a formal and extensive legal procedure for its dissolution or winding-up, as laid out in the Companies Act and the Insolvency and Bankruptcy Code. This process is time-consuming, expensive, and involves appointing a liquidator, settling all liabilities, and obtaining approval from the National Company Law Tribunal (NCLT). The sheer complexity and cost of shutting down an incorporated company is a significant disadvantage.
