Last month's article about structuring one's business as a C Corporation versus a sole proprietorship, an LLC, an S Corporation, or a partnership generated the following letter from a reader:

Q: My wife and I make about $170,000 per year as salaried employees. My wife is currently on severance for a year. She recently got a consulting gig and the client will pay her $50,000 as an independent contractor. I was thinking of setting up a C Corp in my wife's name and getting the check made to the company. My question is that now that the checks are deposited into the corporate account, should I make sure my wife gets paid from the corporate account? I do not want her to be paid on a W2 anymore. Can I just let the corporate account collect money and at the end of the year deduct my expenses and file the federal and state tax on the profit I made? Vern N.

I guess Vern doesn't realize that he just pulled out a big red flag and is briskly attempting to get the attention of the IRS. Sorry Vern, but unless the corporation is broke and unless you have no intention of taking any pay from the corporate accounts, you better find a way to pay wages to the working principals. And I'm talking about wages--a paycheck, not a draw, not a loan, not a dividend.

First of all, it is very important to understand that when you set up your business as a corporate structure, you are creating a strict environment in which you will be conducting business. Aside from tax considerations, it's important to know that corporations are formal entities with ritualistic practices and covenants. Here are a few of the differences between a corporate structure and the loosest business structure available, the sole proprietorship:

  1. A corporation must hold board of director's meetings at least once a year. There is no similar requirement for any other legal form.
  2. A corporation must file separate income tax returns and pay corporate income taxes to the federal and state government (according to your state's requirements).
  3. Corporate funds can be withdrawn by the principals only in specific ways: dividends (which results in double taxation), wages, rents, loans but only if there is a signed note and repayment plan, otherwise the distribution may be reclassified as a dividend and taxes assessed to the recipient and the corporation.

Why is it important to understand these differences? Because, unless you cross your T's and dot your I's, the IRS, or any litigant for that matter, can "pierce the corporate veil" and turn your corporation back into a sole proprietorship. This will expose your personal assets to lien and levy. In other words, every tax purpose, every legal and personal purpose that drove the formation of the corporation will be moot.

To answer Vern's question, and reiterate what I touched on lightly in #3 above, make sure you are on payroll and take wages! And do so before you take dividends or loans or other forms of payment from the corporation. The IRS wants their fair share of employment taxes.

The IRS is a savvy group. They are aware of the methods business owners use to legitimately and illegitimately take money from corporate coffers without inflicting payroll tax liabilities. And they are poised, ready to pounce on anyone who bends the rules to the point of breaking.

In fact, several years ago, the hot audit topic was corporate wages. And the hot audit industry for said topic was attorneys. Audit staff became devoted to reviewing records of Sub S Corporations who had declared exorbitant dividends to their principals (taxable at modest income tax rates without the addition of the dreaded and expensive self-employment tax) and at the same time paying unreasonably low wages to said principals.

The law firm and the attorney's loved this split--they save a bundle in taxes.

But the IRS won't stand for it. "Yeah right. Mr. Hot Shot Attorney is taking down $30k a year in wages and catching a $300k dividend in the mix. I don't think so! We want payroll taxes!"

Before deciding you would like to incorporate your business, make sure you discuss all aspects with your attorney and tax pro. If you play fast and loose with the corporate structure it will come back to haunt you.