Alternatives To Incorporating
As legend has it, an official-looking envelope was once delivered to the home of Joseph Conrad, the Polish-born English novelist and short-story writer. When it arrived, Conrad tossed it onto his desk, where it remained, unopened, for weeks.
Finally, the British government dispatched a messenger to find out why the author hadn't responded to its offer of knighthood. Conrad, it turned out, had been afraid to open the envelope. He thought it was a tax notice.
Since Conrad's time, attitudes toward taxes haven't changed all that much. Most of us still prefer to not think about our tax problems, although, as many accountants will counsel, the only way to beat the tax system is by planning. And one of the keys to planning, for the owners of small companies at least, is to select the right form of organization for their business.
Recent changes in the tax laws, moreover, make this a good time to reconsider whether you should operate your business as a corporation. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) erased one of the primary benefits of incorporation. As of January 1 of this year, owners of corporations can no longer put aside more money for retirement than sole proprietors or members of partnerships.
The new cap on defined contribution plans is $30,000 or 25% of earned income, whichever is less. For defined-benefit plans, the ceiling is the lesser of $90,000 or 100% of earned income. Just a year ago, the maximum companies could deposit in corporate defined contribution and defined-benefit plans was $45,000 and $136,425, respectively. "Now," concludes Robert L. Haddad, a tax partner in the Boston office of Price Waterhouse & Co., a national accounting firm, "the tax reasons for incorporating are not as material as they used to be."
Of course, incorporating still limits your personal liability if the business goes under or if the company is sued. That can be a real plus if your business is vulnerable to product-liability claims. In addition, there are some financial benefits that survived TEFRA. You can, for example, still deduct the costs of medical, life, and disability insurance for principals in the company, says Leah Belfort, tax manager in the New York office of the accounting firm of Fox & Co.
Also, the company can retain some of the profits. "Leave some earnings behind in the corporation," suggests Michael J. Costello, a partner in the Boston office of the accounting firm Laventhol & Horwath. "The first $100,000 of corporate income is taxed at an effective rate of only 26%. If you took out that extra $100,000, you'd be paying an individual income tax on it of 50%."
There is a catch, though. If you accumulate more than $150,000 in earnings in a corporation, you must explain why to the Internal Revenue Service. And that, by itself, can be a problem. Also, by leaving too much money in the corporation, you may be slapped with an accumulated earnings penalty. "The accumulated earnings penalty," says Costello, "is nothing that the taxpayer voluntarily pays. It's a matter of it coming up on an audit. The penalty is 27.5% of the first $100,000 of taxable income that is unreasonably accumulated, and 38.5% on amounts in excess of $100,000 -- and that's in addition to normal income taxes."
Another disadvantage of operating your business as a corporation is that it is expensive. Take New York as an example. "In New York," says Belfort of Fox & Co., "there is a franchise tax for corporations. In New York City, there is an income tax on corporations. Add to that the bookkeeping and clerical costs, and you're out a lot of money."
With sole proprietorships and partnerships, the advantage is that income is recorded on your individual tax return. There is no corporate income tax form to file and no corporate tax to pay. "With a sole proprietorship especially," notes Costello, "you can keep your overhead low. You don't need an accountant to do two forms, so you save yourself the extra accounting fees."
Sole proprietorships and partnerships also permit you to cut Social Security taxes. "If you are a corporation, you must pay FICA taxes at the rate of 13.7%," explains Costello, "whereas if you are a self-employed individual, you pay only a self-employment tax of 11.3%."
The disadvantages of operating as a sole proprietorship or partnership are that health, life, and disability insurance coverage for the principals in the business are not deductible. Also, the owners are personally liable for the debts of the business or if the company is sued for some other reason, such as product liability.
So which form of organization is best for you now? The answer partly depends on your business. "Every scenario is different," says Haddad, "so you really can't avoid pushing a pencil to make these decisions, because it's a little more intricate now. You don't have the overwhelming [pull] of the retirement plans."
Haddad's rule of thumb is to remain a corporation if you need protection from liabilities. "If you're a small retailer," he says, "you probably don't need to be incorporated. But if you're an insulation manufacturer with product liability [hanging over your head], it makes sense to incorporate."
And, Haddad adds, don't overlook the S-Corporation option. An S Corporation offers the same protection as a regular corporation, but income is not subject to the corporate tax. Rather, it flows through your personal tax return -- just as it would if you operated your business as a sole proprietorship or partnership. You have to decide whether this is an advantage, given that you won't have the option of retaining some of the earnings in the corporation.
For more information on forms of organization, try Judith Cowan Zabalaoui's book, How to Use Your Business or Profession as a Tax Shelter (Reston Publishing Co., Reston, Va.; $18), or Irving L. Blackman's The Book of Tax Knowledge (Boardroom Books, New York; $60).