Incorporating could be the perfect suit of armor for protecting your wealth.
By Bonnie Lee
Whether your business is small or large, incorporating is a worthy consideration under Obama’s new administration. Many think of Obama’s administration as small business friendly, however, there is a new mandate to close the $400 billion tax gap and empower the IRS to get every penny it is entitled. Now, more than ever, small business owners need to consider the concept of adding, “Inc.” to their name.
I often advise clients to consider incorporating their business once profits reach a steady $100,000 plus per year. Beyond the tax consequences, the legal aspects of incorporating should be discussed with one’s attorney. The tax consequences, as well as the ability to function within a more restricted structure, should be discussed with one’s tax pro. Employee benefit packages and retirement plans should also be studied for comparison with existing strategies.
When it comes to the income tax picture, income splitting is the primary reason to incorporate as a C Corporation. As a sole proprietor, you are the business. You declare your sales and subtract business expenses on Schedule C of your individual income tax return. Then you pay both income taxes and self-employment tax (15.3 percent) at the individual level.
By incorporating as a “Sub S Corporation,” no tax is paid at the corporate level and all income flows through to your personal income tax return. Since the self-employment tax does not apply to dividends, you will also enjoy some tax savings.
Incorporating gives birth to a legal entity which will exist at arm’s length from your personal finances. If structured as a C corporation, this entity files its own tax returns and pays its own taxes.
Americans enjoy--using the term loosely--a progressive tax system, in which the more you make, the higher your rate and the more you pay. So if your income is cut in half and allocated between your C Corporation and your individual income tax return, you are likely to save a lot of money. You pay taxes on this income at the individual level when you draw income from the corporation in the form of wages, dividends, rents, etc. There may be other non-taxable forms of income, such as employee benefits and expense account reimbursements.
For example, the net profit after paying yourself a reasonable wage, is $100,000. You take a qualified dividend of $50,000 which is subject to a tax rate of 15 percent through 2010. The C Corporation pays corporate tax on the remaining $50,000 at a rate of 15 percent and you have no self-employment tax to worry about. The overall tax rate is 15 percent.
Same scenario but the business is set up as a sole proprietorship: Your tax liability would be about 25 percent on a profit of $100,000 plus an additional 15.3 percent for self-employment tax to fund your social security. Ouch!
Since you are taking wages from the corporation, the 15.3 percent self-employment tax rate will be built in to your withholdings and the employer’s matching share, all classed as payroll taxes, which is a write off at the corporate level. When a sole proprietor pays the self-employment tax, she cannot write it off as a business deduction.
Obama’s tax plan and new tax rates on those making more than $250,000 per year will be affective in 2011. Using income-splitting techniques these higher tax rates can be minimized.
Protection from the IRS
If a C Corporation gets in income tax trouble, the IRS can only go after corporate assets. Like any litigator, they may attempt to pierce the corporate veil, and tap into your personal assets. So make sure you follow the rules.
“There is no personal liability for corporate income taxes unless there is a liquidating dividend or the shareholders fail to maintain clear delineation between corporate finances and personal finances,” says Robert McKenzie, tax attorney for Arnstein & Lehr LLP. He added that if the company is operated properly and not a single member LLC treated as a C Corporation for income tax purposes, there is no personal liability for corporate income taxes.
But look out! If the C Corporation has an unpaid payroll tax liability, the IRS can hold you personally liable.
Why is this so important? Because the “newer and friendlier IRS” has left the building. Obama sees the $400 billion tax gap--unpaid tax liabilities, projected lost tax revenue due to nonfilers, cheaters, and the underground economy--as a potential source of revenue. His mandate to IRS Commissioner Doug Shulman is to “Sic ‘em!” So the IRS is retraining their keypunch staff (don’t need all those clerk typists now that more than 70 percent of the nation is filing electronically) for enforcement positions. The IRS is also adding an additional 3,500 positions in all areas of enforcement from audit personnel to special agents.
With this rocky economy, it might be wise to have a suit of armor to protect your personal wealth.
Consider these factors along with all the issues that pertain to your individual situation. Then sit down with your tax pro and your attorney to determine if incorporating your business is a logical next step.