Monday, August 24, 2009

TO INCORPORATE OR NOT TO INCORPORATE - THAT IS THE QUESTION! - PART I

As a general rule posts to THE WANDERING TAX PRO are limited to 1040 issues, including those that pertain to Schedule C. While I have prepared many “entity” returns (corporation, partnership, trust, non-profit organization – Forms 1120, 1065, 1041, 990) over the years I no longer accept “entity” clients (unless absolutely necessary).

However, as the decision whether or not to incorporate a business activity is in some degree a Schedule C issue I have decided to address it.

While there are two types of corporations (for income tax purposes) – the regular “C” corporation and the “Sub-chapter S” corporation – I will be addressing only the regular “C” corporation in this post. I feel that the advent of the LLC (Limited Liability Corporation) has reduced the benefit of becoming an “S” corporation.

Every person who is starting a business should not automatically incorporate. In most cases the one-person freelancer, “indie” or small business does not need to incorporate. It only unnecessarily and substantially increases costs, paperwork and agita.

There are several benefits, both tax and non-tax, to incorporating a business.

Historically the most popular non-tax reason for forming your business as a corporation is “limited liability protection”. The corporation has been around for a long time and has been proven in the courts over the years as a way of protecting the personal assets of the business owner(s), or shareholder(s). In most cases the creditors of the corporation cannot take the personal assets of the shareholders to satisfy debts or obligations of the corporation. .

For example, if a customer falls in your store (or spills hot coffee purchased from your fast food restaurant’s drive-up window on his/her lap while driving away) and sues you for $2 Million and wins the court cannot force you to sell your personal residence to satisfy the obligation if the corporation only has $10,000 in assets. Or if your corporation has a loan on which it defaults the bank or other creditor cannot go after your personal assets to cover the outstanding balance if the corporation has no cash.

Of course as with any law there are exceptions that allow lawyers to keep their fees flowing in. If it can be proven that you, as owner of the business, were personally responsible for the fall, or personally “contributed” to the fall, you could also be sued as an individual. And if you, as corporate officer, co-signed or guaranteed the loan the bank can come after you personally to make good. There is no way to get full guaranteed “limited liability” protection in all situations – but the corporation has generally been the best way to get the most protection.

But the corporation is not the only business entity that provides limited liability protection. We now have the “Limited Liability Company” or “LLC”. As one would expect from the title, an LLC provides the limited liability protection of a corporation without all the other “excess baggage” that comes with a corporation. I do believe that all states now allow for a one-person LLC. As long as you follow all the legal formalities, as well as keep your personal assets separate from your business assets (such as by maintaining a separate business checking account – are you listening, June Walker), your liability will largely be limited to your business assets

My only caveat is that, although it has been around since March of 1977 (with the passage of the Wisconsin Limited Liability Company Act), and is now an available option in all states, the LLC is still to some degree the “new kid on the block” and its liability protection has yet to be truly tested in the courts.

One tax-related benefit of incorporating is the fact that a business organized as a corporation will have a lesser chance of being audited than a sole proprietorship filing a Schedule C. If you look at two identical businesses – one filing a Form 1120 (the income tax return for a corporation) and one filing a Schedule C – each with identical gross income and business expenses – there is a much greater chance that the Form 1040 with the Schedule C will be chosen for an audit.

The reason for this is a corporation, with gross receipts that if reported on a Schedule C may be considered to be “large” in relation to other Schedule C businesses, will be relatively “small” when compared to the total population of corporations. And it appears that the IRS will be specifically targeting certain Schedule C businesses for audit in the near future as part of its war on the Tax Gap.

This benefit is most attractive to those who do not want to report all of their income to the IRS and/or who want to overstate deductions or claim personal deductions as business expenses. Tax fraud of this type will be less likely to be caught if one files as a corporation.

As for the honest taxpayer/businessperson who will be properly reporting all income and claiming only legitimate deductions – you should not incorporate if this is your only reason for doing so. It is not worth the additional cost and agita. While nobody wants to be audited, if you are one of the unlucky few who are selected, as long as you have been honest and have kept good receipts and records you should be able to successfully “pass” any audit.

Perhaps the biggest tax advantage of a corporation – especially a one-man corporation – comes in terms of tax-free employee benefits and reducing the overall Social Security and Medicare (FICA) Tax liability.

If you are the 100% owner of a corporation and hire yourself as an employee of the corporation you can give yourself many employee benefits, included but not limited to health insurance, life insurance, reimbursement of medical expenses, and pensions, the costs of which are deductible by the corporation but tax-free to you as an employee.

A major financial benefit comes in the way a corporation pays FICA tax on an employee as opposed to the way a self-employed sole proprietor filing a Schedule C pays “self-employment” tax. An employee pays Social Security and Medicare (FICA) tax on “gross wages”. The employer (corporation) pays half as a deductible expense and the employee pays half via withholding. A sole proprietor pays Social Security and Medicare (Self-Employment) tax on “net earnings from self-employment”, which is basically 92.35% of the Schedule C bottom line. The sole proprietor pays 100% of the tax on his/her 1040.

If a one-man corporation wants to “0” out net income by paying himself/herself a salary he/she can use employee benefits to reduce the “pot” that the wages come from. If he/she starts out with $60,000 and can use $20,000 to pay for legitimate deductible employee benefits, including the employer share of FICA tax, than his salary is $40,000 and FICA tax is paid on $40,000.

A sole proprietor’s allowable “employee benefits” (for himself) are deductible from gross income as an “adjustment to income” and not from net earnings from self-employment. If he/she has net earnings from self-employment of $60,000 he can reduce his income tax by deducting health insurance premiums and pension contributions, but he still pays self-employment tax on $55,410 ($60,000 x .9235) – which is $15,410 more than the corporate employee. The result is $2,358 more in Social Security and Medicare taxes paid.

While a corporation can pay and deduct the medical expenses of an employee under a “medical reimbursement plan” and pay and deduct, within limits, certain life insurance premiums, a Schedule C filer cannot claim medical expenses or life insurance as a business expense on Schedule C to reduce net earnings from self-employment. He/she must claim the medical expenses as a personal itemized deduction on Schedule A, subject to the 7½% of AGI exclusion, and cannot deduct life insurance premiums anywhere on his 1040.

Let us look at the real-life example of a client who has a small retail store. He is currently a one-man “C” corporation. His gross receipts for the year were slightly over $200,000.00. He took a salary of $45,000.00, bringing his federal net taxable income to $2.00. As part of the price for the privilege of living in New Jersey he paid $12,857.00 in health insurance premiums for himself and his family through the corporation. The corporation paid $3,734.00 in federal and state payroll taxes in addition to the $3,681.00 in FICA and unemployment and disability contributions (SUI and SDI) withheld from the $45,000.00 in wages. The Corporate Business Tax paid during the year was $500.00.

If the client had operated as a sole proprietor filing a Schedule C the net earnings on his federal Schedule C would have been $62,093.00 ($2.00 corporate income + $45,000.00 salary + $3,734.00 payroll taxes + $12,857.00 health insurance premiums + $500.00 NJ-CBT). His self-employment tax would be $8,773.00 ($62,093.00 x .9235 = $57,343.00 x 15.3%).

The additional tax paid as a sole proprietor would be $1,358.00 ($8,773.00 - $3,734.00 corporate payroll tax expense - $3,681.00 payroll tax withholdings). There would be a very small federal income tax savings - as the net taxable earnings from self-employment, after deducting the health insurance premiums and one-half of the self-employment tax would be $44,849.00 instead of $45,000.00 – but the state income tax liability would be more due to the increased earnings reported from self-employment and possible decreased medical deduction.

This particular entrepreneur did not make a contribution to a pension plan from the corporation. But if he did that would have further reduced the FICA tax liability. If the corporation had made a tax deductible contribution of $5,000.00 to a SEP on behalf of the owner/employee the W-2 wages would now be $40,000.00. The FICA savings on $5,000.00 would be an additional $765.00.

Of course you must also factor into your calculations the state Corporation Business Tax (which was $500.00 in the above example) and the additional accounting and tax preparation fees that a corporation would pay – and, of course, the agita factor.

And there is another tax-related benefit. A corporation provides you the option to select your “fiscal year”. You do not have to report income and expenses on a calendar year basis. You can, for example, choose a fiscal year of July 1 to June 30, or April 1 to March 30. Having a non-calendar fiscal year can provide some tax planning opportunities for the closely-held corporation.

. . . to be continued

Tomorrow - the disadvantage of incorporating.

TTFN

7 comments:

Michael F. said...

Nice post. As a very "green" staff accountant I at a small public firm, I learn a lot from posts like these. Thanks!

Robert D Flach said...

Michael F -

Thanks for the kind words. Glad you found the post helpful.

Be sure to come back tomorrow for Part II.

TWTP

Taxes DIY said...

MY best tip would be to consult a lawyer!

Bruce said...

Best tip is to consult a lawyer? Hopefully not a divorce lawyer.

It is advisable to consult a lawyer I would agree. But not just any lawyer, one that knows his way around the playing field of incorporating.

To continue ones advise (at least mine) when I have clients who are looking at incorporating, I suggest there be a meeting between myself (tax accountant/preparer), their “accountant” if they have one, and the Lawyer. That way the taxpayer/s wishing to incorporate, can get the advice from all angles, thus not trusting the advice of just one “lawyer”.

Robert D Flach said...

Bruce-

The most important advice I can give is to be sure to consult a tax professional FIRST - BEFORE talking to any lawyers. Do not tell your tax pro "after the fact". By then it is too late to cheaply fix a lawyer's FU.

TWTP

Anonymous said...

Although one could "bail out" all the taxable income by paying various forms of compensations, the issue that would arise is whether that amount of compensation is reasonable, given all the facts and circumstances.

Lisa said...

Interesting post! I agree it is necessary to consult with a tax accountant as to what the best incorporation structure would be for a particular client. However, highly expensive lawyer fees may not be necessary when you can incorporate online with a fast, reliable and affordable sources such as CorpNet (http://www.corpnet.com). Their principles have helped more than 10,000 businesses incorporate and get their start.