The decision to incorporate is often one of the first choices new business owners makes, even before they’ve drafted a business plan or secured start-up capital. In many cases, this can turn out to be a costly mistake. While it’s true that incorporating a profitable business can sometimes yield tax savings, most businesses lose money during their start-up years and some businesses never manage to become profitable. Most of the time, these start-up period losses would be more valuable on the owners’ individual income tax returns than they would be on a corporate tax return, and winding-down a business that has been incorporated can be much more expensive than winding-down a business that has never been incorporated. Here are some questions that the business owners should ask themselves before they form a corporation or other legal business entity:
- What benefit will the business get from incorporating?
- When will the business become profitable?
- Does the business include real estate or other property that is likely to increase in value?
- Where will the money to start the business come from?
Sometimes business owners will incorporate just because they think it’s something that people do when they start a business or because they think that they can convert expenses that wouldn’t be deductible without incorporating into business deductions by paying for them as a corporation. The first is generally not true, and the second is almost always wrong. A business can operate indefinitely and never incorporate, and there are very few things that are deductible as a corporation that are not also deductible for an unincorporated business.
Corporations do offer tax savings to some businesses, but for a different reason. A corporation can choose to be either a “C-corporation” or an “S-corporation”. Both types of corporation can offer tax savings by reducing self-employment taxes. C-corporations have their own set of tax brackets separate from their owners. C-corporation earnings are not subject to self-employment tax and the first $50,000 of taxable income in a C-corporation each year is taxed at a 15% rate, but corporations don’t receive a standard deduction or personal exemptions. This can make C-Corporation very attractive for business owners when their companies are profitable and retaining some of the earnings to pay for future growth. They are generally less desirable for business owners who typically take all of the earnings from their companies or each year to pay for personal expenses because these retained earnings cannot be withdrawn from a C-corporation without being taxable to the owners as dividends.
S-corporations don’t offer income tax savings because all of their earnings get reported and taxed on their shareholders’ returns, but they can reduce self-employment taxes. Unlike an LLC with an operating business, S-Corp profits are not subject to self-employment tax, and unlike a C-corporation, S-Corp earnings can be withdrawn without a second level of tax. The tax code requires corporate shareholders who work for their companies to receive adequate compensation in the form of a salary or wages subject to payroll tax. Because S-Corp earnings are not subject to corporate income tax or self employment tax, the IRS reserves the right to reclassify distributions or other payments to shareholders as wages if adequate wages are not paid.
Questions about legal liability should be directed at attorneys rather than accountants, but a common reason to incorporate is for liability protection. A sole proprietor is generally on the hook for any debts incurred by his or her business, including debts that could result from a business-related accident. Operating as a corporation or an LLC can offer a degree of protection for the shareholders’ personal assets if the businesses is unable to pay its bills.
Why not incorporate?
While there can be some very good reasons to operate a business as a corporation, there are also a lot of good reasons not to. Corporations have more tax filing and administrative burdens than unincorporated businesses. Business losses from an unincorporated business often yield more tax savings than similar losses inside of a corporation. Additionally, property can generally be placed in a corporation without a tax cost but usually can’t be taken out without the shareholder having to recognize taxable income. These disadvantages tend to be greatest early in a business’s life.
First, the paperwork burden of a corporation is more than most business owners can handle without paying for outside help. Corporations must file income tax returns separate from their owners. Even if the shareholder is the only employee, a corporation must file payroll tax returns and collect and remit payroll taxes and income tax withholding on the shareholders compensation from the corporation. Most states require corporations to file an annual report each year to remain in good standing and keep its legal protection. Finally, a corporation generally needs to hold annual meetings, maintain minutes, and keep other records that just don’t apply to unincorporated business.
Second, losses in a corporation are often worth less than losses in an unincorporated business. This author has seen more than one case where a married taxpayer starts a business and runs losses for the first several years. Self-employment losses not only reduce taxable income, but also earned income and adjusted gross income. Sometimes this can result in an earned income credit, even when the wage-earning spouse earns more than the earned income credit phase out. The deduction of losses from AGI also helps taxpayers with other income avoid the AMT and claim other deductions and credits that are unavailable to high income taxpayers.
Finally, the tax laws surrounding incorporation are basically a one-way deal. the owners of a corporation can add assets to it all day long without incurring a tax, but most withdrawals from a corporation will be taxed as salaries or dividends. When a shareholder takes something other than money out of his or her business, the IRS considers the property to be sold for whatever it is worth and the cash distributed. This can result in tax for both the shareholder and the corporation.
Operating as a corporation can save a business money on income taxes and give it’s owners some liability protection but incorporating too soon can cause an unnecessary burden and unexpected tax costs. The benefits of incorporating are greatest for profitable, established businesses. New businesses that are just starting our are often better off staying sole-proprietors for a while.
Business owners who are considering forming a corporation for the liability protection should consult with their attorneys to find out if forming an LLC might give them the same protection with less administrative overhead. A single-member LLC owned by an individual files its taxes like a sole proprietor, so forming an LLC creates very little extra paperwork.