Tax consequences of incorporation

Introduction

Deciding to incorporate is based on a variety of different factors. One large factor in deciding whether or not to incorporate is based on the want to reduce personal liability. Business owners want to make certain that their personal assets are protected even if the future of their business is not. Another huge consideration that business owners must make before deciding which incorporation structure to integrate is the tax consequences of those business structures. Some small business owners base their entire business structure decision solely on how they can minimize the negative aspects of incorporation and keep as much money as possible in their own pockets and invested within their business.

The choice of incorporation would be an easy one if taxation implications where consistent. But the truth of the matter is that they can vary greatly not only depending on what business structure that you choose but also what state you live in, how many shareholders you have, whether you are a for profit or not for profit business, etc. There is no right or wrong answer when it comes to deciding on a type of incorporation based in the tax consequences of that corporation, the only right decision is the one that is most appropriate for you and your business' individual circumstances.

In this article you will be given a general overview of the most common tax consequences of the main types of incorporation. Specific note is made that each corporation, no matter the type, will be subject to specific state taxes that are obviously too many to name in this concise article. You should consult with the state office of the state that you are considering incorporation in and obtain the specific tax information that you can then use to determine your decision of incorporation on.

Sole Proprietorship tax consequences

The simplest and most inexpensive method of forming your business is to choose the structure of a sole proprietorship. The sole proprietorship is not technically a corporation, none the less it does have its own specific tax consequences to consider. As far as taxation on your sole proprietorship is concerned, the methods are relatively straightforward. Because there is no legal separation between you as the owner and the business itself, your income is considered the same as your businesses income, just as your liability both personally and in your business are one. Therefore, when it comes time to pay taxes, you simply file all gains and losses on your personal tax return. This can be as simple as filling out a standard 1040 form with the IRS. Because as a sole proprietor you have no employees you are not required to pay any employee taxes nor are you subject to double taxation. Any and all increases for the year are taxed once.

LLC tax consequences

The tax consequences of an LLC are slightly more complex than with a sole proprietorship, but that complexity is a trade off for the limited liability status that is obtained with this business structure. Many see the tax consequences as much less of a disadvantage than having complete liability (or no liability protection) for their business. LLCs are also not technically considered corporations under Federal tax law, mainly because they do not have the authority to issue stock. The business structure of an LLC is still relatively new when compared to other business structures. Therefore, some states are still making decisions as to how they should be taxed. It is not uncommon to see a great deal of deviation when it comes to comparing one state's LLC tax laws with the tax laws of another state. There are however a few general constants that you can count on.

The first is that as an LLC the owner of the company and the company itself are seen as two separate entities. Therefore, taxes will need to be filled for each entity. A second relative constant regarding LLCs and taxation is that most LLCs have a flow through taxation type. Flow-through taxation means that the entity does not pay taxes on its income. Instead, the owners of the LLC pay taxes on what is called their "distributive share" of the entity's taxable income. Federal tax law permits the owners of the entity to agree how the income of the entity will be allocated among them (or in other words what their distributive share will be).

Partnership tax consequences

A general partnership defined as an association between two or more people in business seeking a profit. Like LLCs, general partnerships have pass-through taxation and therefore the owners are key in determining what they will receive and therefore what they will be required to pay in taxes. Unlike an LLC, in a partnership the members of that partnership are personally liable for the debts of the business. Therefore, the formation and operation of a partnership can be very risky if one member of that partnership can incur consequences where the responsibility will be shared by both members of the partnership. General partnerships can be formed with relative ease, but in order to limit the possibility that one partner be responsible for the acts of another partner it is wise to have a written partnership agreement of some type that stipulates the terms of the partnership. Because the liability for the corporation lies with the individual owners, separate taxation of individual and company is not required. The individual owners are taxed on the portion of income that they receive.

Corporate tax consequences

Corporate tax consequences are among the more complex of all the incorporation types. This is mainly because there is more than just one option of taxation when it comes to taking on a corporate entity. Corporations are different from other types of business structures in that is corporation is considered a separate entity from its owners. As a separate entity, corporations enjoy the benefits of having limited liability, easy transferability of shares, and perpetual existence (meaning that the corporation lives on even when the corporate management/ownership undergoes changes). Since a corporation is a separate legal entity from its owners, the corporation is obligated to pay taxes separately from its owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends. The corporation itself also pays taxes with a different corporate rate on any profits.

There are also differences in taxation based on whether the corporation has elected to be classified as a C corporation or an S corporation. C corporations have potential double tax consequences meaning that they must pay taxes when the company makes its profit and again when dividends are paid to shareholders. S corporations can avoid this tax issue, but not all corporations will qualify to be able to be considered an S corporation. S corporation tax consequences require that gains or losses be recognized on sale or distribution of assets at fair market value.

Choosing a state to incorporate in based in tax consequences

You cannot discuss the tax consequences of incorporation without addressing the importance of considering the state that you plan on incorporating in. You may or may not know that you do not have to form your corporation in the state that you are living in. There are ways to register your corporation as a foreign corporation in a state other than your home state. Corporations may choose to incorporate in a state other than their own for many different reasons, but as you may have guesses, one of the main reasons for choosing another state to incorporate in is that an alternate state may have tax laws that are more favorable.

However, caution must be taken when considering which state to incorporate in and selection of the state in which to incorporate must go beyond a simple measure of the state's administrative and tax costs. There are additional costs for incorporation outside of your home state that you must factor into the financial picture. If you incorporate outside of your home state, you will need to employ a registered agent in the state of incorporation. This is required in order for your corporation to officially maintain a physical presence in that state. You may also face having the additional requirements of holding board meetings or annual meetings in the state that you have claimed incorporation in. Furthermore the records of your corporation will most likely be required to be kept in the state of incorporation.

For most companies of modest size it is most logical that the state of incorporation be in the state where the majority of the business will be conducted, meaning the home state of the company. It is not uncommon that the additional administrative and financial costs of incorporating in the other state negate any privacy, protections, or other positive taxation issues afforded by another state's laws. If you still wish to entertain the idea of incorporating in a state that is not your own, it is important to consult with your legal and tax advisors to determine the relative advantages and disadvantages of incorporation in different states as they pertain specifically to your business. This choice deserves careful consideration as the implications of your decision can have significant legal and financial consequences.