EVALUATING INCORPORATION

Incorporating a business can be a major concern for the proprietor of a small or medium size business.

There are two major factors that any proprietor or partner of a business must consider before incorporating.

• Non-tax considerations

The non-tax advantage important to the proprietor who incorporates and maintains the corporation as a separate entity apart from themselves is the avoidance of personal liability. If the business was not incorporated and was sued by the user of their product, the proprietors could conceivably have most of their personal belongings (including their home) taken from them unless they were fully insured.

When a proprietor sets up a corporation, only the corporation’s assets will be subject to a lawsuit. None of the proprietor’s personal assets is in jeopardy. Another non-tax consideration of incorporation is that the owner may obtain additional capital to expand the business by selling shares of stock to family members, employees or outsiders.

In addition, the proprietor may leave control of that business to family members using shares of stock. In other words, a corporation has a perpetual existence. This may ultimately be important to the family since they can still participate in the company’s growth without participating in the management or day-to-day operation of the corporation.

• Tax considerations

The other major consideration in deciding whether to incorporate is the tax factor. Since the enactment of TRA ‘86, corporate tax rates are higher than individual rates. Differing tax treatment is a complicated subject that should be reviewed with an accountant and attorney.

A corporation is a separate entity and consequently is subject to taxation. Normally, income from a corporation is taxed and distributed to shareholders as dividends. The dividends are in turn taxed, thus one is confronted with double taxation.

However, in a situation where losses, not profits, could reasonably be anticipated in the early years of the business, the proprietor may decide to make an “S Corporation Election.” This election would help offset the corporation losses against any other income that the proprietor might be receiving from other employment. It should also be noted that under an “S Corporation Election” the corporation would pay no tax at all. In order to qualify for an S Corporation certain requirements must be met:

• The sub-chapter selection must be filed with the IRS by March 15 of the calendar year of the transition

• All shareholders must give their consent in writing

• An S Corporation must have 35 or fewer shareholders, all of which are U.S. citizens or resident aliens

• All shareholders must be “real people,” not corporations, partnerships or other legal entities (some trusts may qualify)

• S Corporations may issue only one class of stock, but different shares are permitted to have different voting rights

Some business owners use an “S Corporation Election” as a tax saving device by spreading the income to their children. A father with three children, all equal shareholders, would only have one-fourth of the income included in his tax return.

However, if children are not actively involved in the business, the income received could be passive and would therefore be subject to taxation at the parents’ marginal tax bracket on income in excess of the small child’s non-earned income allowance.
As an employee of the corporation, the proprietor is faced with additional employment taxes. A sole owner is subject to only the self-employment social security tax. However, if the proprietor were an employee of the corporation, the corporation would be responsible for paying the employer portion of Social Security and deducting the employer portion from the proprietor’s salary check. A corporation would also be subject to state and federal unemployment tax and workers compensation premiums.

The tax law greatly restricts the employee benefits that may be provided to shareholders of S Corporations (but not regular corporations) that own more than 2% of the stock. Some states prohibit S Corporation status and for those states with higher income tax rates for individuals (such as New York), any Federal tax savings could be greatly offset by the High State Tax Rate.

An incorporation feasibility analysis may be prepared that analyzes the tax treatment of incorporated versus sole proprietor status. Using basic assumptions each course of action may be analyzed and projected. This “number crunching” can provide important evidence for the proprietor to add to the non-tax aspects of incorporation.

Setting up a corporation is a simple procedure with potential for outstanding tax benefits. However, the proprietor should not automatically assume that incorporation would be in his or her best interests. The proprietor should consult with a CPA or attorney in order to determine the feasibility of incorporating.

CORPORATE RESPONSIBILITIES

Government agencies, particularly the IRS, place significant obstacles on incorporated business entities. The filing of reports and record maintenance is a more serious proposition for a corporation. For example, every important act of the company should be documented in the corporate minutes book. Unless specifically authorized, some expenses could be disallowed.