Thinking About Incorporating?
The decision on whether or not to incorporate involves a number of complicated issues. All too often, taxpayers make unwise decisions based on misconceptions of tax benefits available to corporate entities. It is not uncommon at social gatherings to overhear someone talking about incorporating in order to write off this or that. Generally, there is little difference between expenses that are deductible as an individual doing business versus that of a corporation. Although there are some benefits associated with corporations, there are also corresponding negatives. Corporations can take two forms, either a C-corporation or an S-corporation. To gain some insight into the differences between doing business as a corporation or as an individual, let’s review some of the major issues:
Limited Liability – A corporation is an entity unto itself. The shareholder owns an interest in the corporation itself but does not own an interest in the corporation's individual assets. Except in unusual circumstances, a shareholder’s liability is generally limited to his or her investment in the corporation. This is a distinct advantage over an individual doing business, in which both the business and personal assets are at risk.
Double Taxation – Generally, the only way money can be taken out of a corporation is via a reasonable salary, through dividends paid by the corporation, or reasonable interest on stockholder corporate debt. The wages and interest are both deductible to the corporation, but the dividends are not. Thus, there is a potential for double taxation: the stockholder pays individual income tax on the dividends received but the corporation is not allowed to deduct the dividends paid as an expense. If the corporation has a loss for the year, the stockholders (except for S-corporation stockholders) receive no benefit. In contrast, an individual doing business reports on his or her personal tax return the business’ overall gain or loss for the year, and there is never any risk of double taxation. In addition, the individual benefits from a deduction against other income if the business has a loss for the year.
Employee Fringe Benefits – There are a number of fringe benefits available to corporate employees that are not available to or are significantly different for individually-owned businesses. Some of the more popular benefits include pension/profit-sharing plans, group life insurance, group health insurance, disability income coverage, medical reimbursement plans, cafeteria plans and education reimbursement plans. However, shareholders/employees of S corporations do not receive the full range of tax-free fringe benefits that are available to those of a C corporation.
Selling the Business – Generally, selling an individually-owned business involves putting up for sale the various pieces that make up the business such as equipment, real property, goodwill, etc. The business owner is taxed on each piece based on the remaining cost in that item and can sometimes take advantage of the lower capital gains rates. This is also mostly true for S-corporations that sell off the pieces of the business rather than the stock, since they are “pass through” entities. For a corporation, the business can be sold by simply selling the shares of stock to a buyer, resulting in a capital gain (or loss) to the seller. However, in most cases, the buyer prefers an asset purchase, which provides better up-front write-offs and avoids assumption of any prior corporation liabilities. When this happens, the sale of the asset is taxed at the corporation level and will generally be taxed again at the personal level in the form of a dividend, salary, or liquidation.
Administrative Costs - Establishing and maintaining a corporation can be costly. Normally, a lawyer handles the filing of the Articles of Incorporation and states charge for issuing corporate charters. In addition, the corporation must pay yearly fees to maintain its charter and conduct its business. The corporation must maintain a list of all the shareholders and hold at least one shareholder meeting per year, both of which add to its corporate expenses. In contrast, the business operating as an individual does not have these expenses.
Avoid leaping into business structures until you have thoroughly educated yourself and reviewed your options, including exit strategies, retirement plan options, and a whole host of other considerations based on the type of business, business partners, potential liabilities, investment required, estate issues, etc. Please call this office before making your final decision.