Law and You > Corporate Laws > Companies Act, 2013 > Disadvantages of Incorporation of a Company
In this article, we shall study the disadvantages of incorporation of a company. Incorporation has many advantages but to understand the working of a company the disadvantages of incorporation are required to be studied.
Lifting of Corporate Veil:
A company is an artificial person is clothed with a corporate veil. It cannot act on its own, it can act only through natural persons i.e. through the Directors. The corporate veil separates the company from its shareholders. This concept of corporate veil is applied in Solomon v. Solomon case, Lee v. Lee’s Air Farming Ltd. But the theory cannot be pushed to unnatural limits. Circumstances must occur which compel the Court to identify a company with its members. There are certain circumstances when the lifting of the corporate veil becomes necessary. The separate personality of the company and its statutory privileges should be used for legitimate purposes only. Where the legal entity of the company is being used for fraudulent and dishonest purposes, the individuals concerned will not be allowed to take the shelter behind the corporate personality. The court in such cases shall break through the corporate shell and apply the principle of what is known as “piercing or lifting of the corporate veil”. Thus lifting of corporate veil refers to the possibility of looking behind the company’s framework (or behind the company’s separate personality) to make the members liable, as an exception to the rule that they are normally shielded by the corporate shell.
Formalities:
Incorporation requires a host of formalities to be complied with than any other form of the business. Formalities start before the actual incorporation of a company and exist throughout the life of the company and continue even during its winding up. Meetings are to be held on time, accounts are to be maintained as specified and its auditing should be done as per the provisions in the Act in time. Charges and mortgages are to be filed within the prescribed time. Returns are to be filed within time. Appointments of directors, their removal and replacements should be as per the Act. Noncompliance with the Act results in punishment to defaulters.
Expenses:
The initial cost of incorporation includes the fee required to file the Articles of Incorporation, potential attorney or accountant fees, or the cost of using an incorporation service to assist to incorporate the company with completion and filing of the paperwork. There are also ongoing fees for maintaining a corporation. Thus expenses are incurred before the actual incorporation of a company and throughout the life of the company and continue to incur even during its winding up.
More Paperwork:
A lot more paperwork involved in maintaining a corporation than a sole proprietorship or partnership firm. Corporations must maintain a minute book containing the corporate bylaws and minutes from all corporate meetings. Other corporate documents that must be kept up to date at all times include the register of directors, the share register, and the transfer register. Most corporations are required to file annual reports on the financial status of the company. The ongoing paperwork also includes tax returns, accounting records, meeting minutes and any required licenses and permits for conducting business.
Publicity and Loss of Privacy:
If a corporation is an incorporated company, one person doesn’t retain complete control of the entity. The company is governed by a board of directors, who are elected by shareholders. As per the Act, several documents and accounts are to be submitted to the authorities. The files with Registrar of Companies are available for public inspection. Thus the privacy is lost.
Double Taxation:
People who are owners of a corporation, and who also work as an employee of the business, can receive financial compensation in two different ways. In addition to receiving a salary or wages for work performed, the owner may also receive a dividend or distribution on the stock that he or she owns. Any distribution of income to stockholders via dividends is taxable. In the case of corporations such as a C Corporation, have the potential to result in “double taxation.” Double taxation occurs when a company is taxed once on profits, and again on the dividends paid to shareholders.
Denial of Some Fundamental Rights:
The Constitution guarantees fundamental articles under Article 14 to all and under Article 19 to the citizens of India. A company has a nationality, domicile, and residence but cannot ask for the enforcement of those fundamental rights which are exclusively available to national citizens. The nationality of the company, however, does not depend upon the nationality of its shareholders. A company has a nationality, domicile, and residence but cannot ask for the enforcement of those fundamental rights which are exclusively available to national citizens. The nationality of the company, however, does not depend upon the nationality of its shareholders.
In the State Trading Corporation of India v. Commercial Tax Officer, 1963 SCJ 705 case, the company argued that as all the shareholders of the company are citizens of India, the company should be treated as a citizen of India and it should get all the benefits conferred upon the citizens of India. The Court rejected the argument and it was held that neither the provisions of the Constitution nor the Citizenship Act applies to the company. It should be noted that though a company does not possess fundamental rights, yet it is a person in the eyes of law. It can enter into contracts with its Directors, its members, and outsiders.
In Rustom Cavasjee Cooper v. Union Of India 1970 AIR SC 564 popularly known as the Bank Nationalization case, the Court observed that in all cases where the company alleges that its fundamental rights have been violated, it is a fact that the fundamental rights of its shareholders are violated. So, if a shareholder files a writ petition, either by himself or even jointly with the company, his petition cannot be dismissed if he is a citizen of India. In such a case, he does not lose his fundamental right only because he is also a shareholder in a company.
Limitation of Action:
A company cannot go beyond the power stated in its Memorandum of Association. The Memorandum of Association of the company regulates the powers and fixes the objects of the company and provides the edifice upon which the entire structure of the company rests. The actions and objects of the company are limited within the scope of its Memorandum of Association. In order to enable it to carry out its actions without such restrictions and limitations in most cases, sufficient powers are granted in the Memorandum of Association. But once the powers have been laid down, it cannot go beyond such powers unless the Memorandum of Association, itself altered prior to doing so.
Control Possible Without Majority Shareholding:
It is not always the case that the majority of shareholders have the control of the company. If a business family promotes accompany and holds only 10% of its shares, if the rest of the shares are held in small numbers by thousands of shareholders spread over the large geographical areas (country), still the family can have effective control over the company. In such cases, this 10 % of shareholders have 100% control over every aspect of the company. There is a possibility that the resources and finances of the company can be used for personal gains and benefits.
Possibility of Fraud:
When shareholding of a public limited company is spread out among thousands of small shareholders. In such cases, the board of directors has full control over every aspect and resource of the company including finance. In such cases, there is a possibility that the resources and finances of the company can be used for personal gains and benefits. Though there is governmental control over affairs of the company, large frauds have been done in the corporate world.
Difficulty in Closing the Business:
Perpetual existence of a company is considered one of the important advantage of the incorporation. But the same advantage becomes hurdle during the dissolution of the business. It requires significant time and money to complete the necessary procedures for dissolution.
Conclusion:
In conclusion, while incorporation offers numerous advantages such as limited liability, perpetual succession, and the ability to raise capital, it also comes with several disadvantages. Incorporation requires companies to comply with a variety of legal and regulatory formalities, including annual filings, audits, and general meetings. This can be time-consuming and costly, particularly for smaller businesses. In the case of corporations, profits may be subject to double taxation—once at the corporate level and again at the shareholder level when dividends are distributed. Shareholders, especially in publicly listed companies, may have limited control over day-to-day operations, with management and board of directors having significant decision-making power. This separation of ownership and management can lead to conflicts of interest.
Incorporated entities, particularly public companies, must disclose financial statements and other sensitive business information, reducing the level of privacy and potentially exposing the company to scrutiny by competitors, regulators, and the public. The process of incorporation involves significant legal, registration, and administrative fees, making it more expensive compared to other forms of business structures like sole proprietorships or partnerships. Companies are bound by formalities and corporate governance requirements, which can lead to slower decision-making processes compared to unincorporated businesses. Since the management (agents) runs the company on behalf of shareholders (principals), there is the potential for agency problems, where the interests of the management may diverge from those of the shareholders.
These disadvantages suggest that incorporation, while providing legal and financial benefits, may not always be the ideal structure for every business, particularly small or closely held businesses. The decision to incorporate should be carefully considered, weighing the benefits against the associated costs and obligations.