Volume 7 Issue 5
Reasons for Incorporating
© by Tax & Business Professionals
In the last edition of this newsletter we talked about limiting
liability as a reason for incorporating. This edition explores some of the tax and other
reasons for incorporating.
Early in this century, it was commonly believed that only large
businesses like factories and mills were incorporated. These large and often successful
corporations provided benefits, such as retirement plans, medical care, and insurance,
often for management only, that small businesses did not offer.
Beginning in the 1950's, successful sole proprietors and
partners, such as consultants, lawyers, and doctors, began to compare their compensation
and taxes to those of executives of large incorporated entities. It became clear that
something was amiss.
The "something" was corporate tax breaks for
retirement plans, medical plans, and insurance benefits and the like. Such benefits were
both deductible by the corporation and usually not included in the pay of corporate
employees (or the tax was delayed until retirement).
Why, many sole proprietors and partners wondered, can't we
incorporate and enjoy the same types of corporate benefits? Beginning in the early 1960's
and up until the early 1980's, many small businesses did just that, incorporate. By the
early 1970's, the tax reasons for incorporating were so compelling that most highly
compensated professionals and other small businesses were incorporated.
As the scales tipped more and more in favor of incorporated
small businesses, Congress began to give greater concern to IRS protests about the abuses
of corporate benefit plans.
For example, it was possible until about 1978 to have a
self-funded corporate medical plan for employees that allowed the corporation to deduct
all medical expenses for its employees. What irritated some was the definition of
"employee" in such corporate plans.
For example, in a small electrical contracting
firm, "employee" could be defined as "a licensed electrician who is an
officer of the corporation." Since many small firms had only one licensed
electrician, the president and owner, that one person was the only one covered. Congress
felt that such plans discriminated unfairly against most employees and passed new
anti-discrimination tax laws.
Congress Curtails the Benefits
Over time, Congress killed, or greatly impaired, nearly all of
the tax-favored fringe benefits. For example, it imposed discrimination tests which
required that designated percentages of full-time employees be covered before top
management could receive a tax deductible benefit. In other words, the owners and
management could not use tax-favored programs to benefit primarily themselves.
In addition, many of the retirement and other benefit plans
previously available only to corporate entities were extended on similar terms to
partnerships and sole proprietorships.
Before, in the 1960's and 1970's, professionals (and others)
had to incorporate to benefit from the more favorable retirement plans, now they do not
have to incorporate. In other words, we now have substantial parity among the entities
when it comes to choosing tax deductible fringe benefits.
In 1986, Congress expanded the "double tax" on
corporations. Corporate profits and other types of gains are taxed twice, once at the
corporate level and then again when the amount is distributed (less corporate tax) to the
individual shareholder. Moreover, corporate tax rates were raised above some individual
marginal tax rate brackets.
While the double tax bite can be eliminated (or
mitigated) by electing "S" status for closely held corporations, these changes
greatly reduced the need and tax advantages of incorporation. In essence, Congress
neutralized the tax reasons for incorporating.
Non-Income Tax Considerations
Apart from tax considerations and the desire to limit
liability, there are several reasons for incorporating.
Appearance is one reason. Quite frequently, if a person
starting a new business has worked only in a large corporate environment, there is a
tendency to desire a "corporate" title, like "president," or "
CEO." While this title may seem superfluous, in some cases it is understandable if
the entity from whom business is sought expects to deal with "titled"
Another reason for incorporating is the protection of the
entity purchasing the services. Let's say, your corporation regularly retains a number of
free-lance computer programmers as independent contractors.
If a purported "independent contractor" is
reclassified by the IRS as an "employee," the results visited upon the newly
christened employer will be expensive. If individuals providing consulting services are
incorporated, it is less likely that the IRS or state agencies collecting withholding or
unemployment taxes can successfully reclassify them as "employees."
To lessen this exposure, some companies now
require that self-employed individuals incorporate before services are performed.
Previous Article | Next Article
List of Articles by Tax & Business Professionals
Published jointly by The Tax & Business Professionals, Inc. and the law firm of Newland & Associates as a service to their clients.
If you are a tax professional and would like more information about the subjects covered in this newsletter or any other tax and business matter, please call the Tax & Business Professionals, Inc. at (800)-553-6613, e-mail us at
, or visit our web site at http://www.tax-business.com.
For a full range of business law and tax-related services, call the law firm of Newland & Associates at (703) 330-0000.
If you are reading this newsletter but are not on our mailing list, and would like to be, please contact us at (800) 553-6613.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
You can search for information in the entire Authors Row section,
or in the entire site. For a more focused search, put your search word(s) in quotes.
Tax & Business Professionals Main | Authors Row Main | Home