Shakespeare’s difficulty with the decision “to be or not to be” aptly applies to the entrepreneur’s decision whether or not to be incorporated. With inexpensive books on the market covering self-incorporation, there is a strong temptation to incorporate without fully considering its consequences.
Corporate Attraction
An entrepreneur is often motivated to incorporate based on his understanding that a corporation insulates him from personal liability from business debts. Clearly, corporations do limit many creditors to payment solely from the corporate assets.
Corporations also may offer several tax benefits. One major tax benefit is the entrepreneur’s ability to reduce Federal and state income taxes by “splitting” income between the entrepreneur and the corporation. This income splitting occurs to the extent that the shareholder’s wages do not fully offset corporate taxable income.
Because corporations also have tax bracket rates, the first $50,000 or &75,000 of corporate income may be taxed at lower rates than would otherwise be taxed if earned by an individual.
Another corporate tax benefit is a deduction for certain statutory fringe benefits such as group-term life insurance and medical and dental reimbursement plans covering the shareholder-employee. These benefits are excluded from shareholder-employee compensation as tax exempt fringe benefits.
In addition, the corporation can invest in U.S. companies and receive a 70 or 80 percent dividends received deduction. Corporations may also generally adopt a non-calendar based fiscal year-end for tax purposes.
Lastly, an entrepreneur whose shares qualify as “small business stock” may deduct a portion of any loss on a sale or exchange of the stock as an ordinary loss rather than capital losses which are subject to annual limitations.
An incorporated entrepreneur may also consider electing within the first two and one-half months of any year to be an S Corporation. As an S corporation, most income and losses flow to the shareholders and are reported on their personal income tax returns much like a partnership or proprietorship. S Corporations are generally required to adopt and report based on calendar year-end. Although fewer fringe benefits are excluded from an S Corporation’s shareholder-employee compensation, the benefit of allowing corporate losses to flow directly to offset personal items (such as wage or interest income) is appealing.
Corporate Traps
Although incorporation limits liability for business debts, they do not limit liability of professionals (doctors, engineers, architects, etc.) from liability for negligence. They also do not relieve officers and directors from liability for willful or knowing neglect of any corporate taxes. Lenders may also require personal guarantees and secure personal assets of the shareholders prior to funding corporate loans. Similar requirements may be made by lessors.
Corporations require annual shareholder and directors meetings, separate books and records and separate accounting and legal filings, resulting in added administrative costs. If these records are not maintained, corporate creditors may claim that the corporation is legally a sham and seek recovery for business debts and torts directly against the shareholder.
In addition, corporations are less flexible than partnerships (and limited liability companies) as to the allocation of income where there are multiple investors with varying expectations. This is particularly true of S Corporations which are limited to one class of stock. Other types of entities, such as partnerships and limited liability companies offer more options.
Corporations also face a number of unfavorable tax traps. Except for the first tax year, in California, corporations are subject to annual minimum franchise taxes of $800.00, regardless of income or absence of operations. Many other states impose similar minimum fees. If an election is made to be an S Corporation, there is a 1.5% California state tax on net income to the extent it exceeds $800.00. There are also other special taxes that may apply, to a C Corporation such as a personal holding company tax or an accumulated earnings tax. S Corporations may be subject, in some cases to a built-in gains tax and a tax on passive investment income. In addition, the contribution of capital by a new shareholder subsequent to the initial capitalization of the business may result in a taxable even to the new shareholder. These need to be compared to other entities, which may have no federal taxes, but possibly certain California taxes where the legal entity provides some form of limited liability protection to its partners/members.
In addition, if the business is successful, distributions of corporate wealth for the personal enjoyment of the shareholder may become a problem. First, distributions through wages and other compensation are limited to “reasonable compensation.” Reasonable compensation is based on the compensation of similar executives in business of the same size in the industry. Second, corporate dividends (other than certain S Corporation dividends) will be taxable to the shareholder. However, the corporation is not entitled to a corresponding corporate deduction for dividends. Third, liquidations of the corporation could result in substantial capital gains to both the corporation and the shareholder.
Unfortunately, this problem becomes greater over the years. If the accumulation of wealth is substantial, accumulated earnings tax on certain passive income.
Conclusion
While many of the basic considerations for incorporation have been outlined above, there are many others which should be considered. Given the numerous factors involved, the assistance of a professional versed in both the legal and tax ramifications of incorporation becomes essential to establishing the appropriate business form.
