Business Incorporation Issues

Many businesses start out as sole proprietorships or simple partnerships. However, as a business grows and its operations become more complex, many business owners begin to think about incorporating.  The following provides a brief discussion of the more common issues associated with business incorporation.  Please contact us for additional information and assistance related to setting up and maintaining a corporation and the special tax rules that apply.

Limited  Liability

A corporation, as a separate legal entity, is legally responsible for its own taxes, debts, losses, and other liabilities.  If the corporation can't pay, its shareholders stand to lose their investments in the business, but their personal liability is limited.  However, the key word here is limited.  There are numerous situations in which a business owner can be held personally liable for money owed by his or her corporation.  For example, a corporation won't shield a business owner from personal liability for professional malpractice or his or her own negligent acts while engaged in corporate business.

A business owner's personal assets are generally protected from the reach of the corporation's creditors.  However, banks and other creditors frequently require an owner to personally guarantee the corporation's debts. So, if the corporation's assets are not sufficient to satisfy a debt, the owner will have to dig into his or her own pocket to pay up.

A business owner is also generally protected from the long arm of the IRS.  For example, if the corporation falls behind on its income taxes, the IRS can levy on the corporation's assets-but it cannot reach the owner's personal assets.  However, it's a different story when it comes to payroll taxes.  A business owner who has financial control over a corporation can be held personally liable as a “responsible person” if income and payroll taxes withheld from employees' wages are not turned over to the IRS

In some cases, courts have allowed the IRS and other creditors to “pierce” the corporate veil and seize a shareholder's personal assets to satisfy a corporation's obligations.  This can happen when a shareholder so dominates a corporation and the shareholder's and the corporation's assets are so commingled that the corporation is considered nothing but the shareholder's alter ego. You should carefully observe the legal requirements for running the corporation and keep the corporation's money and accounts strictly separated from personal assets.

Tax Savings

Aside from liability limitations, there are potential tax savings associated with incorporation.  The extent of these potential savings depend on a number of factors, including the choice of a corporate form for tax purposes and how the corporation is operated.

C Corporation

When a business incorporates, it is automatically classified as a regular C corporation.   A C corporation files it own income tax returns to report income and expenses, and it is taxed on its profits at graduated corporate rates.  However, C corporations have traditionally had one disadvantage: double taxation.  When C corporation profits are paid out as dividends they are taxed again to the shareholders.

Starting in 2003, the recently enacted Jobs and Growth Tax Relief Reconciliation Act (JAGTRRA) reduces the double tax—but does not eliminate it.  JAGTRRA provides that for tax years beginning after 2002 and before 2009, qualified dividend income is taxed at the same rates that apply to net capital gain.  Thus, the tax rate on dividend income is generally 15% for taxpayers in the higher brackets.  The tax rate is 5% for dividend income that would otherwise be taxed at a 10% or 15% regular tax rate.  However, the 5% rate drops to zero for one year only in 2008.

C corporation owners can escape the double tax to some degree.  For example, certain fringe benefits, such as health and group-term life insurance, are deductible by the corporation and are tax-free to owner-employees.  In addition, profits paid out as compensation to owner-employees are deductible by the corporation and, thus, are taxed only once. However, a C corporation can deduct only a “reasonable” amount of compensation for an owner's services.  Amounts over and above reasonable compensation will be treated as disguised dividends.

On the other hand, double taxation is only an issue for a corporation that actually pays dividends.  Many smaller companies—especially those that are growing and expanding—may operate for many years without declaring a single dividend.  These corporations can generally justify substantial salaries, fringe benefits, and bonuses for owner-employees who spearhead the business.  And any remaining profits are generally reinvested in the business.  A C corporation can accumulate income for expansion and other reasonable needs of the business.  However, a C corporation can be penalized if it accumulates more than $250,000 ($150,000 for personal service corporations) without documenting a specific purpose for the funds.

S Corporation

Like a C corporation, an S corporation is a separate legal entity.  However, it is not a separate taxpaying entity.  As a general rule, S corporation income and losses pass through to the shareholders who report them on their personal returns.

This pass-through treatment may make S corporation status a good choice for a young company that expects losses for several years.  The losses pass through to shareholders and can be used by them to offset other income.  On the other hand, S corporation status may not be good fit if corporate profits will be accumulated for expansion or other reasonable business needs.  Those profits will be passed-through and taxed to the shareholders, even though they won't be paid out as dividends.  Moreover, if a business owner is in a high individual tax bracket, the tax on passed-through profits may be higher than the tax that would be paid at corporate rates.

Business owners should also be alerted to the fact that S corporations face stricter limits than C corporations on the fringe benefits they can provide to owner-employees.  An S corporation can deduct the costs of health insurance and group-term life insurance for employees, but owners of more than 2 percent of the corporation's stock must treat those benefits as taxable income.  On the other hand, there is an opportunity to minimize social security taxes paid by owner-employees.  Rather than paying a self-employment tax on the entire income as would be the case for a sole proprietor, the S corporation owner-employee realizes a savings of approximately one-half the self-employment tax rate applied to the difference between the social security wage limit and the owner-employee annual wages.  Consequently, owner-employee wages must be reasonable.  If too low, the IRS may reclassify portions of corporate income into owner-employee wages. 

Last but not least, business owners should be cautioned that S corporations are creatures of the tax law.  An S corporation must meet strict limits on the number and types of shareholders it may have and on the type of stock it can issue. In addition, the corporation must apply to the IRS for S corporation status.

Changes made by JAGTRRA have changed the traditional dynamics of the choice between the S corporation and the C corporation. JAGTRRA reduces the four highest individual income tax rates to 25%, 28%, 33%, and 35% for 2003 and later years, thus reducing the tax on passed-through S corporation income. However, those rate reductions must be weighed against the significantly lower tax on dividends paid by a C corporation.

Know the Rules 

A corporation—whether it is classified as a C corporation or an S corporation for tax purposes—is first and foremost a creation of state law. Therefore, a business owner must comply with the formal requirements of state law to establish a corporation. To form a corporation, business owners must prepare and file articles of incorporation or a certificate of incorporation with the state in which the business will be incorporated.

The corporation will also need bylaws that spell out how the corporation will be run. These bylaws should include rules regarding shareholder meetings, director meeting, the number of corporate officers, and the responsibilities of each officer.

(Note on Limited Liability Companies - LLC.  Please refer to our separate discussion of LLCs for additional information on this flexible form of business.  LLCs are a creation of state law; generally, federal statues have no separate "LLC" classification.  That is, for federal tax purposes, LLCs are treated as a "sole proprietor," "corporation," etc.)

Exchanging Business Assets for Stock 

When a business is incorporated, a business owner turns the business assets over to the corporation in exchange for stock. This exchange is generally tax free to both the corporation and the business owner. A corporation recognizes no gain or loss when it exchanges stock for cash or property [IRC Sec. 1032(a)]. In addition, there is generally no tax when shareholders transfer property (or cash and property) to a corporation solely in exchange for stock, provided the transferring shareholders are in control of the corporation immediately after the exchange [IRC Sec. 351(a)]. This rule applies both to individuals or groups who transfer property to a corporation. Moreover, it applies whether the corporation is just being formed or is already operating.

The corporation may also assume liabilities connected with the business such as trade accounts payable or equipment loans. The corporation's assumption of these liabilities generally does not trigger a tax to the business owner who is relieved of the liabilities, provided the liabilities will give rise to a deduction when paid [IRC Sec. 357(d)].

A business owner's basis in his or her corporate stock is generally equal to the amount of cash and the basis of property transferred to the corporation [IRC Sec. 358(a)(1)].

Accounting for the Separate Entity

As a sole proprietor, a business owner may have commingled his or her business and personal funds. However, business owners should be cautioned when a business in incorporated, the business assets belong to the corporation. For example, the business owner cannot pledge corporation assets as collateral for a personal loan (although the owner can pledge his or her corporate stock). In addition, as a separate legal entity, a corporation will need a separate bank account and must maintain separate records.

TIN.  A corporation must obtain its own taxpayer identification number (TIN) for income tax reporting and payroll tax purposes. A business owner cannot continue to use the number that he or she obtained as a sole proprietor to report withholding and payroll taxes for employees of the business.

Accounting Method.  The corporation must adopt an accounting method for tax purposes. As a general rule, the corporation may use either the cash or accrual method.

A business that produces, purchases, or sells merchandise generally must keep an inventory and use the accrual method for purchases and sales of merchandise. However, there is an exception for small businesses with average annual gross receipts of $1 million or less [Rev. Proc. 2001-10]. If a business takes advantage of the exception and does not keep an inventory, it deducts the cost of items it would otherwise include in inventory in the year it sells the items or in the year it pays for them, whichever is later.

Tax Year.  The corporation must also choose a tax year.

A C corporation can generally choose any tax year. Thus, the corporation can operate on a calendar year or on a fiscal year that ends on the last day of any month other than December. However, there is one exception. A personal service corporation must use a calendar year unless it can establish a business purpose for use of another year or makes a special tax election to use a different year [IRC Sec, 444].

S corporations must generally operate on a calendar year basis. Because most S corporation shareholders are individuals who operate on a calendar year, this restriction is designed to ensure that S corporation income will pass through to the shareholders in the same year the corporation earns it. A limited exception permits an S corporation to elect a tax year ending on the last day of either September, October, or November. However, an S corporation that makes this election must make special required payments to offset the tax deferral to its shareholders. In addition, an S corporation that receives at least 25 percent of its gross receipts in two months of the year can time its year end to its natural business cycle.

Filing Returns and Paying Taxes.  Corporations file returns and pay taxes on a different schedule than an individual sole proprietor.

A C corporation must file its income tax return by the 15th day of the third month after the end of its tax year (March 15 for a calendar-year corporation). In addition, a C corporation must make quarterly estimated income tax payments unless its tax for the year is expected to be less than $500. Estimated tax payments are due on the 15th day of the fourth, sixth, ninth, and twelfth months of the corporation's tax year.

Although it is not a taxpaying entity, an S corporation must file an annual return reporting its gross income and deductions and information concerning its shareholders. As with C corporations, the S corporation return must be filed with the IRS by the 15th day of the third month after the end of the tax year. In addition, an S corporation must furnish each shareholder with a copy of its return on or before the day the return is filed [IRC Sec. 6037]. Each shareholder must also be provided with a schedule showing his or her share of the corporation's income or loss for the year as well as separately stated items that could affect the shareholder's personal tax liability for the year.

Home | About Us | Contact Us | Notices | Resale Cert