Deciding whether to incorporate a business requires careful analysis.  Often the taxpayer will be faced with competing choices of operating the business as a sole proprietorship, or as an S corporation.  Simply because nontax factors favor incorporating, do not assume that tax considerations will also yield the same conclusion.

Tax consequences vary greatly depending upon the business form which the taxpayer chooses.  Moreover, there will often be a tension between business and tax objectives.  For this reason, the taxpayer should be alert to the tax rules that will govern a newly formed corporation.

If There Were No Taxes

If the taxpayer could decide whether to incorporate based upon the unrealistic assumption that taxes were not a consideration, he or she might consider the following advantages to operating the business as a sole proprietorship (i.e., not incorporating):  First, the business would be simple to operate and would be burdened by a minimum of legal restrictions.  Second, the owner would receive all of the profits and would have the power to make business decisions easily.  Third, the business would be easy to terminate, should that eventuality ever transpire.  Finally, operating the business as a sole proprietorship would avoid incorporation costs, among which include legal fees.

Arrayed against these impressive advantages come, naturally, disadvantages to operating the business as a sole proprietorship.  Foremost among those disadvantages would be the exposure of the sole proprietor:  with no corporation to “shield” the sole proprietor from creditors, the owner would be legally liable for all debts of the business; creditors could reach even personal assets having no connection to the business.

Superimpose Taxes

Now, assume business objectives favor incorporation.  What tax consequences will attach to that decision?  (Note well that if the decision based upon nontax factors had been not to incorporate, only once in a blue moon would tax factors exert a pull strong enough to warrant reconsideration of the business decision not to incorporate.  Put another way, only rarely will tax considerations alone justify incorporating.)

The first and most important tax consequence of incorporation is that a new taxpaying entity has been created, which must file returns and pay tax.  The new corporation, like an individual, must pay tax on its income. Shareholders of the new corporation do not pay tax when the corporation earns income, but instead pay tax on distributed earnings of the corporation, which occur, inter alia, in the form of dividends.

That shareholders are ultimately taxed on the same income that the corporation had been previously taxed illustrates the corporate phenomenon of double taxation.  To make matters worse, the corporation is not entitled to a deduction for dividends paid to shareholders.  On the other hand, paying reasonable salaries to shareholders of closely held C corporations (which payments are deductible as a business expense to the corporation) may be an effective way to bleed a closely held C corporation of earned income while at the same time preserving a deduction at the corporate level.

Another unfavorable tax consequence of operating the business as a corporation versus a sole proprietorship lies in the former’s inability to offset its losses against other nonrelated business income of the taxpayer.  In contrast, losses of a sole proprietor will offset other income, provided the sole proprietor materially participates in the business.

Although some of the painful tax consequences (double taxation, requirement that interests be freely transferable) of choosing the corporate form can be lessened by organizing the business as a sole proprietorship or partnership, the corporate form is often indispensable, since only it affords limited liability to the equity holders.  Similarly, although the formation of an S corporation can mitigate the harsh sting of double taxation, it too has limitations, both in availability, as an initial matter, and also in the requirement that S corporation shareholders be taxed every year (regardless of whether there has been a corporate distribution or dividend) on their “distributive shares” of the S corporation’s income.  Thus, for tax purposes, S corporations in many ways resemble partnerships.

Corporate Income Tax Rate

As a  direct result of their independent tax status, C corporations must compute their own income and deductions, file their own returns (i.e., Form 1120), and pay their own taxes.  Like individuals, gross income of a corporation is expansively defined to include most items that increase net worth.  Unlike individuals (but like sole proprietors) corporations will be entitled to deduct various business expenses.  Some corporations will also be entitled to take what is termed a “dividends received” deduction.  The Tax Reform Act of 1986 lowered the tax rate for corporations with income over $75,000 to 34%.  Lower rates apply to corporations with income under $75,000.

In summary, the act of incorporating should not be taken lightly:  although legal dissolution will terminate a corporation’s tax liability, the tax cost of such a legal dissolution may be prohibitive, due to the largely unavoidable taxes associated with liquidating a corporation.  [Internal Revenue Code, Sections 301 et seq.]