Many think that incorporating their business will help them slash the federal tax bill or avoid state income taxes completely. First-time entrepreneurs often have misconceptions about incorporation, usually resulting from an optimistic desire for lower taxes or thirdhand advice from a friend of a friend’s accountant.
When small business owners fall prey to some of these urban myths, the consequences can range from higher taxes to misunderstanding their personal liability. Here are five common misconceptions surrounding incorporation that are worth unraveling:
Misconception #1: Incorporating can helps with avoiding state taxes. Those starting a business in California might be jealous of neighbors in Nevada who don’t have to pay state income taxes. Many entrepreneurs believe that they can incorporate their enterprise in a low-tax or no-tax state and their business isn't required to pay any income taxes. It sounds like a great strategy, but it won’t work.
When it comes to state taxes, it doesn’t matter where the business is incorporated. What matters is where the owner operates the enterprise. Those living and running a business in California still need to pay state taxes on the income earned in California even if the company is incorporated in Nevada. (Likewise, if a person incorporated the company in California but operates the business entirely in Nevada, then California taxes on the income are not required.)
Never choose a firm's state of incorporation based on state taxes. The owners of larger corporations might opt for incorporation in a state like Delaware for its pro-business laws and court system. But it’s usually best for a small business owner to incorporate in the state where he or she lives and operates the business.
Misconception #2: Incorporating protects the owner from all personal liability. Incorporating or forming a limited liability company (LLC) is a critical step for separating an owner from the business. But it isn’t a magic solution absolving the owner of all personal responsibility. As the owner of a business, he or she can still be held personally liable for the business in several situations. If a business owner signs a contract in his (or her) name, personally guarantees a loan, does not keep up with corporate compliance paperwork or commits a crime, he or she will be personally liable.
Misconception #3: Incorporating confers more deductible expenses. Many believe that corporations can take extra tax deductions. Whether the company is a sole proprietorship or a corporation, ordinary and necessary business expenses can be deducted. An owner won’t be able to start expensing personal vacations, though, just because the company has been incorporated.
Incorporating a business can save money in payroll taxes and self-employment taxes, as well as grant more flexibility in terms of the benefits offered. But never incorporate a business with the thought of being able to take more tax deductions.
Misconception #4: It's better to wait until a product is ready for the marketplace. Many small business owners prefer to avoid legal paperwork until they absolutely have to deal with it. Some believe there's no need to incorporate until they start selling a product or service. At that point, incorporating (or forming an LLC) can help minimize the owner's personal liability should a customer sue him or her.
This line of thinking is wrong on two counts: First, liability issues related to a business can arise long before products hit the marketplace. The business may never get off the ground before it's necessary to fold it. Or a freelancer, vendor or employee might sue the owner.
The second reason to incorporate early is related to an owner's future exit from the company. Let’s say an entrepreneur hopes to eventually sell the business. In this case, it's more desirable to treat the sale proceeds as long-term capital gains than ordinary income. But the stock must be held for more than one year.
Misconception #5. Incorporating can shelter income. When a corporation earns a profit and doesn’t pay it out to its shareholders, these stakeholders don’t need to pay income taxes on the profit. This can prompt many first-time entrepreneurs to think they can shelter their income by keeping cash inside their corporation.
The corporation is required to pay income taxes on its profits. So in essence a small business owner still needs to pay taxes on the income. But it’s noted on the corporation’s tax form as opposed to on his or her individual tax form.
In addition, when the business owner takes those profits out of the business in the form of dividends, he or she will also need to pay taxes on the dividends on a personal tax return. This “double taxation” burden is why many small businesses opt for S Corporation tax treatment for their corporation or limited liability company.
Make no mistake: It’s critical to form a corporation or limited liability company for entrepreneurial activities to minimize personal liability. In some cases, these business structures can lower what an owner pays in taxes. But incorporating should never be considered an easy way to avoid taxes or taking personal responsibility for actions.