Monday, July 6, 2009

FAQ: Should I Incorporate My Business?

The primary advantages of operating as a corporation are liability protection and potential tax savings. Like any important decision, choosing whether to incorporate involves weighing the pros and cons, and should only be done after careful research and consultation with a legal or tax professional.

Once incorporated, the business assets of the corporation are separated from the owner’s personal finances. As a result, the owner’s personal assets generally can be shielded from creditors of the business.

To maintain this legal separation (and avoid “piercing the corporate veil”), the corporation must observe certain formalities, including:

  • Keeping corporate assets and personal assets separate (no commingling of funds)

  • Holding shareholder and director meetings at least annually

  • Maintaining a corporate record book including bylaws, minutes of shareholder and director meetings, and shareholder records

  • Filing annual information statements with the Secretary of State

  • Filing a separate tax return for the corporation

Many people are concerned about “double taxation” of income, but you should do your own research, and compare the features of the C-corporation and S-corporation. The double taxation results when a C-corporation has profit at the end of the year, and that profit is then distributed to the shareholders. That profit is taxed to the corporation, at the corporate tax rate, and then the dividends are taxable income to the shareholders on their personal tax returns. However, the corporate tax rate is typically much lower than the individual tax rate that a sole-proprietor will pay on a 1040 Schedule C, and a competent accountant can help the corporation minimize double-taxation (or eliminate it completely).

For example, a small C-corporation will likely have a shareholder who is also an employee. Paychecks to the shareholder/employee are, of course, tax deductible to the business. To the shareholder/employee, they are taxable income (as would be the case with a paycheck from any employer). A bonus could be paid to the shareholder/employee in order to lower the corporation’s taxable profit, eliminating the double-taxation. These calculations should be performed by your accountant or tax advisor, but shifting income from the corporation to the shareholder/employee (or vice versa, depending on which has the lower tax rate) can be a great way to lower your overall tax liability. In addition, there are certain advantages that are only available with a C-Corporation, such as full tax-deductibility of medical benefits for a shareholder/employee.

The S-Corporation avoids the double-taxation by offering a tax structure similar to the Limited Liability Company (LLC, which is not an option for businesses that are required to hold a license, certification or registration). A corporation with 100 or fewer shareholders can elect to be treated as an S-Corporation. If the corporation is profitable, the shareholder/employee must draw a reasonable salary (and pay employment tax on it), but then all remaining corporate profits flow through to the shareholder’s personal tax return (thereby avoiding the FICA tax on the portion of profits that is taken as a dividend).

Before deciding to incorporate, you should seek legal and tax advice on what type of ownership best suits your business. An experienced attorney and tax advisor can help you decide which form of ownership is best for your business. For the do-it-yourselfers, we highly recommend “Own Your Own Corporation” by Garrett Sutton, Esq. (part of the Rich Dad series).

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