SEE YOUR TAX PRO FIRST!

I have covered this issue here at TWTP before – but it bears repeating.

A recent discussion thread at a tax preparer Facebook group concerned a potential new business client with three partners and 5 already created “entities” (corporation, partnership). 

Pardon my cynicism (especially when it comes to lawyers) but I expect the 5 entities were created on the advice of an attorney without regard to the tax consequences – an attorney who would get 5 separate fees.

To be fair, an attorney may not necessarily be trying to pad a bill when providing incorporation advice and suggesting multiple entities – but the attorney may not be fully aware of all the tax consequences of the entities, and their interactions, that they propose.

 

Very, very important - if you are considering entering into a business enterprise visit your tax professional and your accountant (if not the same person or firm) before you visit your attorney.  Often times getting out of an entity formed in error can be more expensive than forming the entity. 

It may turn out that you don’t need the attorney at all – a one-person LLC or corporation can be formed easily and inexpensively directly with the appropriate state agency online without a lawyer.  And it is important to be aware that formal incorporation is not always the best way to go for a one-person business (although being an LLC, if not a corporation, is). 

However if there are more than one individuals involved in the business, more often than not you will need a lawyer to make sure that you are fully protected – from your potential partners in the enterprise.  You may need a lawyer to draw up the business agreements for the partnership and your own personal lawyer who represents you alone to review the agreements.

Bottom line – when considering going into business consult a tax professional first!

TTFN

ANOTHER ONLINE DEBATE

It seems my announcement of THE SCHEDULE C LETTER has re-opened the online debate of “Should a Sole Proprietor Incorporate, or A One-Person LLC Elect To Be Taxed As A Corporation, For No Other Reason Than to Reduce the Chance of an IRS Audit?”

Here are the comments, the first from me, to the post “To C Or Not To C, That Is The Question” by Russ Fox at his blog TAXABLE TALK.

“Russ-

Thanks for mentioning my new THE SCHEDULE C LETTER, and for the recommendation.

I do agree that all sole proprietorships should register with the state as a one-person LLC for the limited liability protection – but I definitely do not believe that they should all, if possible, file as a corporation.

From my newsletter’s sample issue -

‘An LLC can elect to be taxed as a corporation - but if you want to be taxed as a corporation you should, in my opinion, actually incorporate the business activity.

There exist situations where it may be “more better” to operate your business as a corporation. The decision to incorporate takes very serious study and consideration. I suggest you consult with a tax professional – and not a lawyer – before making such an important decision. It is very important that you review the tax consequences of dissolving the corporation as well. Like a marriage – a corporation me be relatively inexpensive to get into, but very expensive to get out of!’

And –

‘Do not overreact and incorporate your sole proprietorship, or elect to tax your one-person LLC as a corporation, solely for the reason of avoiding an audit.

The advice that one should incorporate solely to avoid an audit seems to me to be saying, ‘If you want to cheat on your taxes you can incorporate and the IRS will not audit you’. It is not good tax or financial advice. Be wary of so-called professionals who give this advice – they may be more interested in boosting their fees than in providing you with good advice.

I have said time and again that an IRS audit is not something that should be avoided at all costs. Tax returns should be prepared, and decisions about choosing a business entity should be made, in such a manner as to generate the absolute least amount of federal, state and local taxes (income and payroll) within the parameters of federal and state laws. If you will pay less tax (income and payroll), fees and other costs by filing a Schedule C you should do so, honestly and ethically, and not worry about being audited.

If your return is prepared correctly, and you document all items of income and deduction properly upfront, then an audit is nothing more than an inconvenience.’

I might also add that filing as a corporation has the potential for a lot of unnecessary agita for a small business sole proprietor.

Thanks again for the plug and for your confidence in my competence as a tax advisor.”

TWTP”

Russ replied –

“I don’t have much to add to what you wrote. I strongly believe that entity formation has three components: tax, legal, and the goals of the owner(s). What is correct for one person may not be correct for a second person. Anyone starting a new business needs to consult both a tax professional and an attorney.”

To which I responded –

“Russ-

I do agree – but consult the tax professional first, and discuss what the lawyer had to say with the tax professional before taking any action.”

Russ does make a good point – “What is correct for one person may not be correct for a second person”. To say that all sole proprietors should either incorporate or, if an LLC, elect to file as a corporation PERIOD is, as I said above, very bad advice.

Does incorporating, or filing as a corporation, reduce the likelihood of an IRS audit? Yes. But this is only one aspect of the decision, and a very minor one at that. Are all Schedule Cs audited, or will they be? Of course not!

Operating or filing as a corporation has the potential for much more unnecessary agita and increased costs (taxes and, especially, professional fees) and paperwork than any audit!

So what do my fellow tax professionals and tax bloggers think?

TTFN

MY COUPLE OF CENTS

I believe there is nothing wrong or unethical with a tax preparer telling a client that becoming an S-corporation will reduce one’s chance of an audit.

Saying to a client, “A business organized as a sub-chapter S corporation is less likely to be audited than one organized as a regular C corporation or a sole proprietorship” is apparently merely making a statement of fact, the proof of which is readily available to the public in published IRS statistics.

I do, however, believe that tax decisions should be made based on tax law and not on potential audit risk, that organizing one’s small business as a sub-chapter S corporation is not the best option in many if not most cases, and that advising a client to organize one’s business as a sub-chapter S corporation for no other reason than to avoid an audit is terrible tax advice.

If a tax preparer is going to tell a client that a sub-S corporation has less of a chance of being audited he/she also has the obligation to tell the client that becoming a sub-S corporation, or a regular C corporation, involves substantially much more paperwork, filing requirements, expense and agita then becoming an LLC taxed as the default entity, and can have the potential for substantial additional tax at termination or, in the case of a sub-S, reclassification to a C corporation.

A good tax professional will review all the entity options available to the client, and apply the pros and cons of each option to the specific business operation and tax situation of the client. While audit potential may be a consideration in the overall decision, it is an extremely minor one.

I have always said that “an IRS audit is not something that should be avoided at all costs. Tax returns should be prepared, and decisions about choosing a business entity should be made, in such a manner as to generate the absolute least amount of federal, state and local taxes (income and payroll) within the parameters of federal and state laws. If you will pay less tax (income and payroll), fees and other costs by filing a Schedule C you should do so, honestly and ethically, and not worry about being audited. If your return is prepared correctly, and you document all items of income and deduction properly upfront, then an audit is nothing more than an inconvenience.”

I have also said -

“I believe it is bad advice to tell ALL taxpayers who have a Schedule C business to incorporate. There is no tax advice that applies to all businesses in all situations (except don’t cheat). The decision to incorporate a business requires careful review of all the specific facts and circumstances of the individual situation. And taxes are not the only consideration.”

TTFN

DO IT YOURSELF!

Earlier this week I pointed out that telling all Schedule C filers to incorporate, and telling a one-person business to incorporate solely for the purpose of reducing his/her audit profile, is truly bad advice (click here for post).

But I did add that there are times when it may indeed be cost effective for a closely-held business to incorporate.

If, after careful consideration of all the facts and circumstances and a detailed cost benefit analysis, and after consulting with a competent tax professional, you decide that it would be appropriate to incorporate your one-person business you certainly do not need a lawyer to do so.

While I am not familiar with all the states procedures, I expect that you can incorporate easily online via the website of your State. Last year I formed a NJ corporation online in about half an hour.

FYI, registering your business as an LLC is equally as easy and can generally be done online.

You can also very easily get an Employer Identification Number from the IRS at the Service’s website.

You also do not need a “Black Beauty” or other such corporate package with by-laws, corporate seal and personalized stock certificates, which lawyers are fond of selling at a nice mark-up, or pay an inflated fee for a lawyer to prepare corporate bylaws.

You can download free blank stock certificates and corporate by-laws and purchase an inexpensive corporate seal from a variety of online sources. I expect you can also find free pro-forma corporate resolutions online. Just do a “Google” or other search.

What do you think a lawyer will do when preparing your by-laws? He/she will have a secretary or paralegal clerk go to the firm’s work processing inventory, pull down pro-forma by-laws, and type in your name and information. And when a lawyer forms a basic corporation the same secretary or paralegal goes online and files the appropriate forms. Even when there was paper filing the secretary or clerk would do all the work. You can do this just as easily yourself for free.

Here are a few online resources (FYI I have no personal experience with or connection to these resources):

PRINTABLE STOCK CERTIFICATES

CORPORATE BY-LAWS

CORPORATE BY-LAWS

CORPORATE SEAL

Where you may need the assistance of a lawyer, experienced in tax matters, is if you are forming a partnership, to help with the writing of the Partnership Agreement. And, of course, you also may need to consult a lawyer when forming a more complex corporation, with multiple shareholders of differing inter-relationships.

You certainly should sit down with a competent tax professional, experienced in business taxes, and go over all of your options in detail, and perform the requisite cost benefit analyses, before making any moves.

TTFN

WHO'S AFRAID OF THE BIG BAD AUDIT?

A tax audit is indeed an inconvenience, and has a great potential for agita and aggravation, but it is not something “evil” that must be avoided at all costs. As I have blogged in the past, if your deductions are legitimate and properly documented you should have nothing to worry about.

While my office audit experience over the past 38 tax seasons has been minimal, considering the volume of returns I have prepared during the 38 seasons, I have found the IRS auditors with whom I have had dealings, while of varying degrees of competence and tax knowledge, to be, for the most part, pleasant and cooperative. I have, thank my lucky stars, never had to deal with a real male sex organ.

My audits have usually ended in “no change” or a minimal mutually agreed on small balance due. I do recall that on one occasion it was determined that the IRS owed my client about $20.00 – but we said we would rather have a “no change” determination than get a check for such a small amount.

In my “wanderings” on the internet I have come across a tax professional who, a while back, appeared, or so it seemed to me, to be advising clients and readers alike not to claim legitimate deductions on a 1040 simply because they fall into an assumed or proven IRS “red flag” category and might increase the chances of an audit.

According to this tax pro it is more important to avoid an audit than to file a correct and accurate return, and it is more important to avoid an audit than to pay the absolute least amount of income tax possible.

I firmly believe in this quote from former IRS Commissioner Donald Alexander (as usual, the highlight is mine)–

"As a citizen, you have an obligation to the country's tax system, but you also have an obligation to yourself to know your rights under the law and possible tax deductions -- and to claim every one of them."

If you actually spent the money for the item and the item is a legitimate tax deduction, and you can prove with physical documentation that you actually spent the money and that it is a legitimate tax deduction, claim it!

If you do not claim the deduction you are automatically auditing your own return and voluntarily overpaying the IRS, and probably also your state tax authority as well.

The same tax professional recently reported, and rightfully so, that IRS statistics indicate that Schedule C businesses are audited much more frequently than corporations. The professional went on to advise clients and readers, “This reason alone is sufficient to justify the additional costs and paperwork associated with forming a separate legal entity and filing its annual report and tax return”.

Again the tax pro says avoiding an audit is the most important factor to be considered.

I do agree that a business enterprise filing as a Schedule C “sole proprietor”, whether registered as an LLC or not, is more likely to be audited than one filing as a corporation. In my recent 2-part post on the advantages and disadvantages of incorporating I explained that –

“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.”

But the only taxpayer for whom this benefit should be the only reason for incorporating is the crook who wants to commit tax fraud, either on his/her own or with the assistance of an unethical tax preparer, by not reporting all income and/or overstating deductions and claiming personal items as business expenses.

The honest taxpayer/businessperson who will be properly reporting all income and claiming only legitimate deductions, and who keeps good receipts and records, should consider this tax advantage of incorporating as “icing on the cake” if, and only if, an extensive cost benefit analysis indicates that incorporating is justified. Or perhaps the deciding factor if it is a very close call.

Other tax bloggers have given more appropriate advice about incorporating in their postings -

• As I quoted in the above referenced 2-part post, TAX GIRL Kelly Phillips Erb, a tax attorney, has said, “In most cases, a C corporation is ‘overkill’ for a freelancer with no immediate plans for expansion, hiring of employees, etc.”

• Joe Kristan, in his post “Corporations: Yea or Nay?” at the ROTH AND COMPANY TAX UPDATE BLOG, says, “Which entity is best? That's a discussion to have with your tax advisor. If you don't know what to do, start with the partnership or proprietor formats; if nothing else, they are the easiest formats to change. C corporations are the only ones that can cause your income to be taxed twice -- when earned and when distributed -- so make sure you really know what you're doing before you go that way.” Joe’s post also includes a quote from another party that best describes the situation – “Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of."

• John Sheeley, an Enrolled Agent and business advisor, writes a blog at www.johnsheeley.com that I recently discovered when he chose to “follow” me on Twitter. In his post “Choosing the Correct Business Entity Type” from earlier in the year he advises – “Always meet with your accountant or attorney BEFORE committing to the formation of a company. Make sure you form the right type of entity, in the correct jurisdiction. One size (or entity type) does not fit all.”

In my aforementioned 2-parter I revise John’s advice to say – “the first person you consult about such a decision is a tax professional, and not an attorney”.

The bottom line - You shouldn’t be so afraid of an audit of your return by the IRS that it causes you to pay extra income taxes by not claiming legitimate documented deductions, or causes you make a foolish move (incorporating) that will end up costing you a lot more money in the long run and result in unnecessary additional paperwork, filings, and agita, if you are an honest and ethical taxpayer.

Now if you are a crook that is another matter.

TTFN

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

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.” .

TTFN

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