Forming a personal corporation means more than having an impressive business card. There are multiple tax advantages.
Illustration by MOTHER EARTH NEWS Staff
Every year, thousands of self-employed people trade their job-related independence for the regular wages and fringe benefits available only to salaried workers. And as part of the deal, they actually give their workshops and tools to their new employers. Stranger still, many of these ex-self-employed workers even insist that their new bosses move in and share their very homes!
And how do these corporate employees, these wage slaves, feel after they've handed over almost everything but their underwear? Well, most of them feel even freer and in charge of their lives than when they were working for themselves. I should know: I'm one of them. And my wife is another. And if you are self-employed, or even if you run a sideline business, maybe you should weigh the pros and cons of finding a corporation to work for, too.
As I'll bet you've guessed, the "boss" I'm talking about is a personal corporation or a family corporation owned by your family. In my case, it's Coburn & Mehs, Inc., the firm my wife, Doreen, and I founded last summer. I'm the president, and Doreen holds all the other offices. Although we own 100% of the stock, the corporation gives us paychecks ... so, technically, we're employees.
But before I get too carried away with telling you about the benefits of incorporating (and there are many such advantages), I should put things into a realistic perspective: While incorporating can prove invaluable to many self-employed people, a lot of other folks are better off on their own. Individual tax situations can pretty well legislate the decision for many of us. But there are other considerations involved — factors that might be more subtle, but are equally important.
For instance, even if you satisfy yourself that you can save a bundle by incorporating, are you willing to take on the additional accounting and paperwork chores required of a corporation? If filing and bookkeeping send you screaming out the door, you'll either have to hire an assistant, change your attitude and learn what you'll have to know in order to keep the IRS of your back yourself, or forget about forming a corporation at all.
But now let's take a look at the reasons so many people are electing to incorporate their businesses.
First of all, you don't have to be rich to gain from taking this step. I recently quit teaching to become a free-lance writer. Doreen is a chemistry instructor and works part-time for our corporation as a chemical consultant.
We have no stock portfolio, and we own no property except our home. All in all, we're a two-person family with one middle-class salary, a bunch of small irons in the fire, and a high stack of hopes. And yet, in its first six months, our corporation saved us more than $1,000.
A Corporation Is a Separate "Person"
When you incorporate, you transfer title to whatever assets you wish the corporation to use in its business. For example, we put cash in a money market account. From then on, Coburn & Mehs, Inc. earned — and therefore was liable for the taxes on — the interest. Similarly, a corporation collects the money its employees bring in: MOTHER EARTH NEWS won't pay me a cent for this article, but it will send a check to my employer.
So even though I am writing this article, the payment for it will go to Coburn & Mehs, Inc. You cannot mix corporate funds with your personal account. Period. The IRS requires stockholders to maintain an "arm's-length" relationship with their corporations; and there are extra rules to assure that "personal corporations" like mine keep their distance from their owners. If you are self-employed, you can grab a dollar from the till and buy yourself a yo-yo. But once you create "You, Incorporated," you can no longer casually snitch even one thin dime.
While the arm's-length rule sounds like a nuisance, it brings about many of the best reasons for incorporating. Why? Because if a transaction would be legal and reasonable between you and a business run by strangers, then it's generally legal between you and your corporation. You, Incorporated can't do something as patently put-up as renting office space in your garage for $7,000 a week. But it can lend you money, borrow from you, pay for your business trips, carpet your office, and do nearly anything else the friendliest firm in town does to keep its workers happy.
Another distinct advantage of the separate person status of corporations—and in fact, what some people consider the biggest advantage of all to incorporating—is "limited liability." So long as a corporation abides by all the formalities, its owners' assets can't normally be attached to pay the firm's debts or any legal judgments against it. So if Coburn & Melts, Inc. went bankrupt, the court couldn't take away my cat, my computer, or any other personal possessions. (Unless, that is, I had given away this right of separation by signing an agreement to guarantee a corporate debt personally.)
Be sure to keep the notion of limited liability in mind if you incorporate and are considering which assets to transfer. For example, it's usually not wise to give a corporation the title to your home. And one more tip: Don't use limited liability as an excuse for being underinsured; your firm should carry adequate coverage to protect itself.
All in all, creating a new corporate person will multiply your options — but it will also increase your chores. It's like holding two poker hands with the right to swap some cards between them: Your chances of winning will zoom, but you'll have more cards to keep track of. Let's look at some of the stakes.
Corporations get big tax breaks. First, they pay taxes only on profits, not on income. Most expenses, including salaries, are deductible. Hence, many corporations go for years without paying any taxes.
And beyond the obvious tax breaks, there are the more subtle advantages of being able to do financial trade-offs between your personal income and that of the corporation, to legally lessen the tax liability of either or both of you.
For example, domestic corporations pay no tax on 85% of the stock dividends they earn from other corporations. If Amalgamated Granola pays you and your spouse $450 in dividends, you're taxed on $250 of it (the $450 dividend less a $200 personal exemption). But if You, Incorporated holds the stock, only $67.50 is taxable (15% of the $450 dividend).
Also, leaving earnings in a corporation — rather than drawing them out as wages or dividends — can cut your tax bill as long as your corporation is operating in a tax bracket that's lower than your own. (That's often the case, since corporate tax rates currently are 15% on the first $25,000 of profits, and 18% on the next $25,000.) So, if Pete the Plumber, Inc. earns $10,000 more in a year than Pete needs in order to meet his personal expenses, and if Pete's personal tax bracket isn't lower than that of his corporation, he'll likely save a bundle by letting his firm hold on to the extra ten grand.
A fear held by many people is that if they incorporate, they'll be taxed twice on the same money. Well, double taxation can't be dismissed as a myth, because there is a half-truth to it. It doesn't apply to salaries, because corporations aren't taxed on their expenses. However, if Pete the Plumber, Inc. distributed X thousand dollars as stock dividends in 1984, Pete sure would pay twice: His firm paid taxes on the money in 1983, and now he'll have to pay personal taxes on the dividend.
That could be a real problem, you say? Yes, it could. But fortunately, there are several perfectly legal ways to draw money from your corporation that avoid both the personal-tax increase of higher wages, and the double-tax trap of dividends. Here are a few examples:
Pay yourself rent. I'm writing this in one of two rooms we rent to our corporation. Because our fledgling firm still has more outgo than income, the rate is low — as cheap as any office rent available in town. And, since our rental income last year was $99 less than our costs for those two rooms, we were able to claim a loss on our personal income tax even though we were collecting rent from the corporation. Furthermore, as corporate earnings grow, the rent can grow in pace to offset the additional corporate income. (In that case, we'll lose the personal deduction of the net loss of the rented rooms, but we'll still enjoy a net gain by switching the deduction to the corporate side of the house, where additional deductions will become more and more valuable as corporate income increases.)
Let You, Incorporated buy or lease from you. We wanted a computer for word processing. At first, we assumed that it would be better for our corporation to buy it. Then we reconsidered: Our personal income is greater at the moment than the firm's income. So as long as our corporation can hold its profits to zero through wages, rent, supplies, and other expenses, why waste a deduction it doesn't need? Instead, we bought the computer and leased it to the corporation (at a low rate to keep personal income down). If our firm prospers and tax necessities shift accordingly, we can sell the computer to Coburn & Mehs, Inc. — once again swapping expenses between personal and corporate to attain the greatest overall tax benefit.
Other expenses. If our corporation flourishes, it will send me off on writing research trips. Pete, Inc. might decide to enlarge its shop. I'm confident that You, Incorporated could also find ways to increase expenses legitimately in order to reduce profits, while benefiting from the expenditures.
Again, everyone's finances are different; there's no single best way to do trade-offs. You might profit by leasing a truck to You, Incorporated, while your neighbors save by leasing from their corporation ... yet all of you would reach the goal of dropping the total tax bill through shrewdly splitting personal and corporate expenses.
The Fringe Benefits Are Outstanding
Unless you're much richer than we are, You, Incorporated will have the ability to offer many more benefit options than it'll be able to fund. As your earnings grow, though, you'll find that sweetening the benefit pot is one of the most efficient ways to increase expenses for the corporation. Here are a few examples:
Medical plans. For now, health care is the only benefit Coburn & Mehs, Inc. can afford to give its workers, but it pays 100% of our medical and dental bills. A corporation — and only a corporation — lets us deduct any medical plan we like. The only thing a medical plan can't do (and this is true of most fringe benefits) is play favorites; if we hire others, our plan must cover them, too.
Tax-sheltered pensions. If you can spare part of your pay, You, Incorporated can offer many ways to shelter it. Corporate retirement plans have several advantages over IRA's:  You can shelter far more than the $2,000 IRA limit.  As administrator of your company's plan, you can manage its investments.  Your plan can allow you to borrow from it.  You must withdraw IRA funds when your age is between 59 1/2 and 70 1/2; corporate plans set their own deadlines. (But beware: Designing a pension plan that the IRS will approve is complicated and may require help from an accountant or an investment counselor.)
Insurance. A corporation can buy disability insurance and up to $50,000 of term life insurance for its employees. It can insure anything it owns, as well.
Continuity. A corporation widens your options for estate planning. It lets you pass your assets on, a few shares at a time, both while you're here and after you're gone. A corporation also makes it easier for your business to continue after your death.
Stability. My wife and I think of stability as an emotional fringe benefit. We like the way our firm helps us even out our up-and-down earnings. Doreen never knows how much her consulting will bring in, and writing is a notoriously chancy trade. But Coburn & Mehs, Inc. sets our salaries annually, based on a conservative guess at earnings for the coming year. If our guess for this year turns out to be wildly wrong, we'll adjust our wages next January. But within the year, we know exactly what personal income we're working with. The corporation is our fiscal voltage regulator.
The Birth of a Corporation
If I've whetted your interest in incorporating, your first step is to do more reading so you'll know what you're getting into. Even if you intend to hire a lawyer or a CPA to help you set things up, the more you know about the subject, the easier it will be for a professional to assist you.
If you'd like to do your own incorporating (that is, without the aid of an attorney or accountant), you should go on from general reading to a book like Ted Nicholas's How to Form Your Own Corporation Without a Lawyer for Under $50 (Wilmington, DE: Enterprise Publishing, $19.95, 1983).
Doreen and I opted to visit an attorney because we wanted expert advice on designing our own bylaws. Incorporating with only the aid of a book is like buying one-size-fits-all caps: They do the job, but never as well as something custom-fitted to your particular head.
We didn't, however, consult a CPA, but sometimes I think we should have. Though I've posted reminder lists of all federal and Colorado (my home state) paperwork due dates, I still have occasional nightmares that an IRS agent is going to nab me for not filing some sort of mysterious schedule Y, U, C, or K — or for failing to meet some other requirement that I don't even know exists. An accountant could have set up our books and provided a paperwork "calendar" that would at least tone down my nightmares.
As for procedures for incorporating, the details vary by state, but the broad outlines are generally similar. If you use a lawyer, figure on at least two sessions. The first will be for recording the information needed to draw up your articles of incorporation and bylaws; the second will involve going over those papers and holding the first corporate meeting. Between sessions, your attorney will ask the state to issue a certificate of incorporation and to confirm that no one else has taken the name you hope to use. You or your lawyer must apply for state and federal identification numbers. And one of you must order a "corporate kit" — a binder containing stock certification, a stock transfer ledger, and room for minutes and papers. The kit will also include your corporation's official seal.
The legalities aren't the whole story, either. With or without the help of a lawyer-midwife, you're giving birth to a new creature so be ready for more maternity bills. You'll surely need a corporate checking account. You, Incorporated may also want a money market savings account, and it may need credit cards. Perhaps you'll want new stationery and business cards, as well.
Overall, though, there's not too much fuss. You, Incorporated should be alive and kicking six weeks after conception.
And Now, the Bad News
The thrill of giving birth to your corporation should keep you going through the initial flurry of paperwork. Try to hoard some of that enthusiasm for later. After all, the clerical chores will be around as long as You, Incorporated is — and such firms can live for a long, long time.
Here's an overview of the fun in store: As a taxpayer, a corporation files state and federal income tax returns. If it's showing a profit, it also deposits estimated income taxes. As a boss, it withholds employees' income and social security (FICA) taxes and accounts for them with a quarterly form; if the quarterly amount comes to more than $500, it makes a deposit in a designated federal depository (usually a bank or savings and loan). It pays federal and state unemployment taxes, as well as the boss's share of FICA taxes. And to celebrate the New Year, a corporation issues W-2 forms and sends copies to both state and federal tax offices. Most corporations also provide workmen's compensation and handle the paperwork that goes with it.
In short, incorporating will force you to become your own business office. You, Incorporated will bring you many prizes, but they'll all come wrapped in red tape.
The Rewards Can Make It All Worth While
For Doreen and me, the advantages of incorporating have been enormous. Our first half-year's savings repaid our initial costs five times over. We're also in better control of our money because we've multiplied our financial options.
Incorporating isn't for everyone, though. You've got to love chopping taxes — love it enough to endure the drudgery of paperwork. But if the idea of keeping the IRS out of your pocket puts a gleam in your eye, you're likely to find that giving birth to a boss will make you a proud and happy parent.
A Reading List for Self-Incorporators
Take time to browse the business section of a bookstore or library. There's no lack of good sources of information, so don't settle for anything written in gobbledygook. New laws can cause big changes, so be sure the books you choose to study were written or updated recently. My wife and I found the following titles helpful during the process of planning and forming Coburn & Mehs, Inc.
Inc. Yourself, by Judith H. McQuown (New York: Warner Books, $6.95 paperback, 1979). Easy to read. McQuown gives sample returns to show exactly how incorporating lowers taxes. Unfortunately, she offers a rather skimpy discussion of doing trade-offs with your corporation.
Incorporating Your Business, by John Kirk (Chicago: Contemporary Books, $15.00 hardbound, 1980). Less fun than McQuown, but much more thorough. Kirk offers especially good chapters on "Special Problems of Closely-Held Corporations" (that is, family-owned) and on tax hazards to avoid.
How to Save 50% or More on Your Income Tax — Legally, by B. Ray Anderson (New York: Macmillan, $14.95 hardbound, 1982). Though Anderson preaches too much, he's full of sharp ideas. He offers an excellent, detailed comparison of sole proprietorships, partnerships, regular corporations, and Sub-chapter S corporations.
Tax Guide for Small Business
is the name of a 168 page paperbound pamphlet style book produced by the Department of the Treasury, Internal Revenue Service. It's free at any IRS office, helpful, readable, and it includes a long list of other free government tax publications, plus an order form.