Tuesday, August 25, 2009


In Part I we discussed the tax and non-tax advantages of a corporation. Now for the disadvantages of incorporating.

Fellow tax blogger, and tax attorney, Kelly TAX GIRL Erb provided an excellent review of business entity choices a while back in a guest post at the PROBLOGGER.NET blog titled “6 Types of Business Entities to Consider for Your Blogging Business”. In it she says –

The disadvantages of a corporation are increased administrative expenses, compliance formalities and the potential for ‘double taxation’.”

These disadvantages all add up to one big one – substantial additional cost! There is no doubt in anyone’s mind that it costs a lot more to form, maintain and eventually dissolve a corporation (whether “C” or “S”) than any other form of business entity.

Kelly tells us that, “Increased administrative expenses are due to more complicated accounting and tax compliance (i.e. filing corporate returns).” And, of course, the substantially increased compliance formalities, substantially more than other forms of business organization, result in substantially increased costs for accounting and tax preparation and federal, state and local taxes and fees.

’Double taxation’”, Kelly tells us, “is the result of a C corporation being a separate taxable entity and not a pass through. This means that the C corporation pays a tax on its income for the corporate year and the shareholders pay tax on dividends received from the corporation.”

One must consider state as well as federal tax costs. While on the federal level if you have no net taxable income you pay no federal income tax, many states charge a “minimum tax” or “franchise fee” for the privilege of operating as a corporation in the state. My state of New Jersey is especially abusive in this area. A corporation could have “0” taxable income yet still pay from $500.00 to as much as $2,000.00 in “minimum” Corporation Business Tax!

And let’s face it - choosing to incorporate also substantially increases not only your paperwork and expenses but also your potential for agita and aggravation. Because there are a lot more complicated rules a corporation must follow there are a lot more things that can go wrong – and very expensively wrong.

A final disadvantage of a corporation is the potential cost in time, agita (again) and dollars to “dissolve” the corporation. With marriage you can pay a couple of bucks for a licence and be wed by a municipal judge – but you could pay a fortune to get a divorce. It is similar with a corporation. You can easily, and relatively cheaply, incorporate online (I just did it the other day in NJ for $125.00 in about 15 minutes) – but there can be a lot of paperwork and potential expense involved to end the corporation, as well as, once again, the potential for “double taxation”.

When dissolving an incorporated business the best course of action for the seller is to sell the shares of the corporation – which will result in a capital gain transaction on Schedule D of the sellers Form 1040, probably taxed at the lower capital gains rate (which this year could be “0”). However most buyers do not want to do this. They would prefer to purchase the individual assets of the business activity from the corporation. There is no special capital gains tax rate for corporations. A corporation is taxed at regular corporate rates on any gain from the sale of its individual assets. The double taxation comes into play when the corporation, in dissolution, passes on the cash from the sale and any remaining assets to the shareholder(s).

Lawyers love corporations and generally recommend it automatically, regardless of whether or not it is truly the best business entity form for the particular situation. Why? Duh - It generates lots of fees!

One does not need to pay a lawyer an excessive fee (for about a half hour or less of his/her secretary’s time to type a pro-forma certificate) to form a basic one-person corporation. It is a very simple process. And now that many states (like New Jersey) allow one to incorporate easily online with almost immediate conformation it is even simpler.

Obviously with more complicated specific circumstances involved in the individual corporation, multiple private stockholders and/or unique/diverse issues and intricacies, one should indeed consult a qualified attorney experienced in corporate law (including federal and state corporate tax law).

Of course not all lawyers are money-grubbing shysters. There are indeed exceptions who will offer true and honest advice to small business clients based on the individual facts and circumstances. For example in the guest post by tax attorney Kelly Phillips Erb mentioned earlier it is correctly and wisely pointed out that, “In most cases, a C corporation is ‘overkill’ for a freelancer with no immediate plans for expansion, hiring of employees, etc.”

Because of the possible tax savings but guaranteed additional costs involved any individual who is considering incorporating his/her one or more person business should do some very serious number crunching first to determine if there is a true potential cost benefit to making such a choice. It is very important that the first person you consult about such a decision is a tax professional, and not an attorney. It is possible that you may eventually need to consult with an attorney, but certainly not before carefully reviewing all the facts with a tax pro.

My bottom line - unless employee benefits such as health insurance premiums, medical reimbursements and pension contributions are a material issue, my recommendation for one starting out in business is to do so as a one-person LLC electing to be taxed as the “default entity” – with one person that is a sole proprietor filing Schedule C. If you find down the road that you would be better off as a corporation you can always change your form, either by remaining an LLC and electing to revise your tax treatment or by actually incorporating the existing business.

The costs of forming and maintaining and dissolving an LLC are still minimal, especially when compared to the costs of forming and maintaining and dissolving a corporation. As has become true with corporations, it is very easy to form an LLC online at your state’s website. You do not need a lawyer to form a basic one-person LLC.

The final word - Perhaps the most important statement made in Kelly Erb’s above-referenced post is – “Laws vary from state to state as to how various entities are structured {and taxed – rdf}, so check with your tax or legal professional for specifics: I can’t stress this enough.” .


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