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CHAPTER 1
So You Want to Be a Corporation
Now that your appetite has been sufficiently whetted by visions of tax-free sugarplums, let's get down to basics.
Do You Have What it Takes to Be an Entrepreneur?
Consultant Brian Azar, "The Sales Doctor," has worked with several thousand people in the past 10 years. He has created the following quiz to predict entrepreneurial success.
On a scale of 1 (lowest) to 5 (highest):
1. Can you work on your own, independent of others, for long periods of time?
2. Can you sell yourself, your ideas, products, concepts, or services? In other words, can you persuasively and effectively communicate to others and be able to draw them into your point of view or project as collaborators, supporters, or customers?
3. Do you have good people skills, such as bonding and rapport? Coaching and managing skills? Sales skills?
4. Do you have good organizational skills: time management? Communications — oral and written?
5. Are you organized, structured, and disciplined?
6. Can you make decisions quickly while maintaining your flexibility?
7. Can you learn from your mistakes?
8. Can you take calculated risks, as opposed to procrastinating?
9. How well do you handle money?
10. Do you know your bank manager's first name?
11. Do you have persistence, tenacity, stamina — especially when the going gets tough?
12. Do you have a "mastermind"? (A mastermind is a group of people — mentors, role models, peers, other entrepreneurs, or small business owners — who support and may assist your vision and goals in various ways.) Finally, and most important:
13. Do you have an idea, service, or product that you love? That you believe in?
A perfect score is 85; a very good score is 60 or higher. Use this quiz to identify the areas in which you need to improve your entrepreneurial skills.
Don't ignore this self-examination. According to Azar, four out of five small business owners go out of business within five years, and it's not for financial reasons. The top four reasons are:
1. Lack of organizational skills.
2. Poor attitude.
3. Poor sales and marketing skills.
4. Poor people skills.
Don't be a casualty — be a success!
Advantages of Inc.-ing Yourself
Until now, most self-employed people have been operating as sole (or individual) proprietorships, a form of business organization in which the individual provides the capital, starts and runs the business, and keeps all the net profits and is taxed on them. As a sole proprietorship, the individual assumes total liability.
One step up in complexity from the sole proprietorship is the partnership, in which two or more people act as joint proprietors: they provide joint funding, joint management, and joint financial responsibility. Unfortunately, like the sole proprietorship, the partners are personally liable to an unlimited degree for all the other partners' errors.
A corporation is the most sophisticated — and protective — form of business organization. It is a "legal person," completely separate from the individuals who own and control it. A corporation has the power to do anything any person may do: carry on business, own property, lend and borrow money, or sue and be sued. Most important, it offers its shareholders limited liability: its stockholders can lose no more than their original investment; they are not liable for the debts of the corporation.
In terms of limited exposure to liability alone, it pays to incorporate in order to protect your assets. If you incorporate, no one can attack your house, car, or Ming vases if your business fails or if you lose a lawsuit. Although this point is particularly important in such obvious professions as medicine, dentistry, law, architecture, and the construction industry, limited liability plays an important role in lesser-known areas.
One of my friends incorporated himself to produce illustrated science fiction and children's books. For him, too, the primary benefit of incorporation has been limited liability: "I publish authors whose work some people might find offensive and they might sue me as the publisher. Rather than reject authors whose work I respected, but who might be dangerous, it seemed safer to incorporate. If I were sued, I wouldn't be personally liable."
Although limited liability may be the most attractive feature of incorporating, there are many others. For many people, there is greater ease in doing business. Some stores favor corporate accounts and offer discounts — even Tiffany's.
Incorporating can make job possibilities more attractive to new or future employees. There's a feeling of working for a profitable enterprise associated with incorporation; you can offer employees greater benefits out of pretax dollars. And, of course, you can always offer them a promotion in title instead of a raise.
Then, too, there are medical, life, and disability insurance benefits. Although the Tax Equity and Fiscal Responsibility Act finally let Keogh plan contributions achieve parity with corporate pension contributions, your benefits will be still greater if you incorporate. Incorporation offers you free life and disability insurance. There is even one kind of insurance you can't get as a self-employed person but can get as the employee of your corporation, even if you are the only employee: worker's compensation.
Medical benefits alone can make it worth your while to incorporate. If you pay your medical bills as a sole proprietor, the amount you can deduct from taxable income is reduced by 7.5 percent of your adjusted gross income. For most people, these deductions can wipe out more than $5,000 in medical bills every year.
But your corporation can write off all your family's medical bills; they're considered a business expense.
Is your business so profitable that you've been investing in stocks? Good. Whereas before, as a sole proprietor, you had to pay income tax on all your dividends, now, if your corporation invests in those stocks, 70 percent of those dividends are completely excluded from income tax, and the remaining 30 percent are taxed at only 15 percent if your corporate net taxable income was $50,000 or less, and at only 25 percent if your corporate net taxable income was between $50,000 and $75,000. The maximum rate is 39 percent on corporate net income between $100,000 and $335,000. Then it drops back to 34 percent on net income between $335,000 and $10 million.
That's the good news. There are a few drawbacks, but they're mostly minor ones. There will be more paperwork, and you will have to set yourself a salary and live within it. There will be a greater number of taxes to pay, but your total tax bill will be much lower than it was as a sole proprietorship — especially if you live in states or cities that impose taxes on unincorporated businesses.
It's pretty clear that the advantages far outweigh the disadvantages, and that's why more and more people are following their lawyers' and accountants' advice and incorporating!
The Myth of Double Taxation
A little knowledge is a dangerous thing. Here's proof: if you tell friends and colleagues that you're thinking of incorporating, sooner or later one of them will say to you, "But you don't want to do that — you'll be subject to double taxation."
This statement is fallacious at best and disingenuous at worst. It confuses two separate issues. You will have to pay two taxes — corporate and personal — but you won't be taxed twice on the same money. What's more important, your total taxes will be less — often by 30 to 50 percent, as compared with an individual proprietorship.
Let's look at some examples. In the first set of figures, our entrepreneur hasn't incorporated. Using 2012 tax rates, he would have to pay $8,599 if he was single and $6,161 if he was married, assuming that he had no children and was filing a joint return with no other income.
However, if our entrepreneur incorporates, pays himself $30,000 a year and retains $30,000 in the corporation, the numbers change dramatically.
There has been much talk about lowering income-tax rates for very small corporations, but as of November 2013 no legislation has been enacted.
The more money you earn, the more you can save by incorporating. Splitting a net income of $75,000 into $25,000 salary and $50,000 retained corporate earnings results in much greater savings, especially for married entrepreneurs.
The following table shows how favorable corporate tax rates are compared to personal income tax rates.
Thus, on the first $75,000 in income each year, incorporating can save you almost $3,000 to $5,100 a year on your federal income taxes if you are single. There is no immediate benefit if you are married, as a result of the Bush tax cuts, which created a 10-percent bracket and increased exemption and standard-deduction amounts.
The most important point, of course, is that by incorporating, you can divide your income into two portions, as shown earlier, each of which may be taxed at a lower rate.
Are You Ever Too Young to Incorporate?
Although the voting age has been lowered to 18, in some states, you still must be 21 to incorporate. From a practical point of view, most experts recommend incorporating as soon as possible. Incorporation has many intangible benefits for young people. The young publisher I mentioned earlier says, "I find it easier to deal as a corporation. I have less trouble in getting good people to work for me; they feel that a corporation is more responsible financially. It seems to increase my financial stature, even in my personal life. I had fewer credit-investigation problems when I wanted to rent an expensive apartment."
Are You Ever Too Old?
Of course, the older you are, the fewer years you have in which to accumulate tax-sheltered retirement funds. Still, according to one Boston banker, "People in their 50s can still incorporate profitably; it all depends on how much money they're earning every year. A successful professional can certainly make use of incorporation in order to provide substantial retirement funds even if retirement is ten, five, or even only three years away."
Hope for Corporate Casualties
I hope that these comments will give much-needed hope to recent corporate casualties. Just a few years ago, layoff announcements of 50,000 employees were front-page news. Today they are commonplace. According to the U.S. Department of Labor Mass Layoff Statistics, actual layoffs in the 44-month period from January 1, 1998 through August 31, 2001 totaled 6,761,377. (I did not want to quote statistics that include September 11 and its devastating economic fallout.)
The bankruptcies of Fortune 500 companies Enron and Kmart in late 2001 and early 2002 and their ancillary layoffs brought this frightening five-year total to more than 8 million.
But these horrifying numbers pale in comparison to the Great Recession of 2008–9, caused by the collapse of the housing bubble, and criminally careless and foolhardy mortgage-banking policies. In just 18 months, 7.4 million people lost their jobs. And on April 13, 2013, a Google survey reported that there were 11.7 million unemployed or underemployed Americans.
Many people who were laid off have years of experience that they can put to good use when they go into business for themselves.
Are You Ever Too Rich to Incorporate?
Yes, there really is such a thing as making too much money to incorporate. Your corporation can accumulate $150,000 to $250,000 — no questions asked.
Above that figure, you must prove that your corporation needs the money for business purposes. Otherwise, the IRS will take the position that your company has liquid assets that are "greatly in excess of its reasonable business needs" (IRS regulations quoted) and will impose additional punitive taxes on the corporation.
Your corporation then comes to the crossroads, where it must either declare a dividend, on which the stockholders would be taxed, or justify the accumulation by showing "specific, definite, and feasible plans" (IRS regulations quoted) for the use of that accumulation. (Office or inventory expansion would be considered such a reasonable use.) If the accumulation cannot be justified, the IRS sets a penalty tax on the "accumulated taxable income": the retained earnings in excess of $150,000. The tax is 27.5 percent of the first $100,000 of this accumulated taxable income and 38.5 percent of everything in excess of $100,000. This corporate tax is an additional tax on top of the normal corporate income tax, so the total tax can go as high as 75 percent.
Thus, if your corporation's retained earnings are approaching the $150,000–$250,000 limit, it should avoid this tax by raising your salary, paying you a bonus, investing in new office or other equipment, or preparing plans that would justify the accumulated capital to the IRS.
Only a corporation that has been grossing about $200,000–$250,000 a year, however, or a corporation that has been in existence a number of years (long enough to have accumulated a substantial surplus) and is considered "mature" is faced with these problems. For most people who are thinking of incorporating, consideration of the accumulated earnings tax on surplus is premature and should not be a factor in their decisions.
There's another point, too. Until 1976, the amount a corporation could set aside as surplus without penalty was only $100,000; the Tax Reduction Act of 1975 increased that allowance to $150,000, and the Economic Recovery Tax Act raised that limit for many corporations to $250,000. Although the rate of inflation is the lowest in more than a decade, with the millions of baby boomer entrepreneurs influencing legislation, it is likely that soon that allowance will be increased again, just because these limits have not been adjusted in more than 37 years. If your corporation's net after taxes is $15,000, it would take 10 years to reach the IRS limit, and many tax changes are likely between now and then.
Are You Ever Too Poor?
Yes, again. It doesn't pay for someone who is earning $30,000 or $40,000 a year to incorporate. The real benefits start at around $60,000 a year. At $60,000 net taxable income, single entrepreneurs are in the 28-percent bracket margin. However, if they draw a salary of $30,000 instead and retain $30,000 in the corporation, they are taxed at a little less than 15 percent on the $30,000, and the corporation is taxed at 15 percent on the $30,000. For married people, real tax advantages start at around six figures net taxable income, as a result of the Bush tax cuts.
But You Can Be Too Undisciplined
For some people, the joys of corporate tax savings just don't outweigh the extra paperwork and planning that are involved. In contrast to the "good old days" of sole proprietorship, when you could write yourself a check or raid petty cash whenever you ran short, now you must clearly differentiate between the corporation and yourself, and act in accordance with the fact that you are now an employee of the corporation — even if at the same time you are its president and only employee. The corporation is a separate legal entity, and as such, there are certain formalities and restrictions. One of the tests the IRS uses to disqualify acorporation is "the corporate pocketbook"— the mixing together of personal and corporate funds.
Are you recognizing that you and the corporation are two separate, distinct legal entities, and does your bookkeeping reflect that fact? Or are you still commingling corporate and personal income and expenditures? I know one man who does this and even pays the milkman with a corporate check; he leaves the mess to his accountant, who straightens it out every year. But this procedure is — to say the least — highly inadvisable.
In order to avoid having your corporation disqualified on these grounds, it is necessary that you set yourself a liberal salary — and live within it, because you can no longer tap the bank account whenever you run short.
More Talk About Salaries
But deciding on a salary is not as simple as it seems at first glance. If you operate a business as a sole proprietor, you pick up all the income of your business. But if you incorporate and pay yourself a high salary, the IRS may attack your salary as unreasonably high and disallow it. Or the IRS may hold that your salary is reasonable, but if you don't have a history of paying dividends and your income has been accumulating, the IRS may deem part of your salary to be a dividend, and it will be taxed to you accordingly.
Part of the question of reasonable versus unreasonable salary depends on what other people in the same business or profession (or a comparable one) are earning. However, even this point can be gotten around. For example, if you are in a creative profession, the IRS really cannot find an equivalent: there's just no way of comparing two artists or two writers, or their incomes.
(Continues…)
Excerpted from "Inc. Yourself 11th Edition"
by .
Copyright © 2014 Judith H. McQuown.
Excerpted by permission of Red Wheel/Weiser, LLC.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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