Eric Tyson - Small Business Taxes For Dummies

Courtesy of the Internal Revenue Service

FIGURE 2-1:The corporate tax form — IRS Form 1120 — entails a high degree of difficulty. Shown is page one.

The chief reason to consider incorporating your small business is for purposes of liability protection. Attorneys speak of the “protection of the corporate veil.” Don’t confuse this veil with insurance. You don’t get any insurance when you incorporate. You may need or want to buy liability insurance instead of (or in addition to) incorporating (see the next section for details). Liability protection doesn’t insulate your company from being sued, either.

When you incorporate, the protection of the corporate veil provides you with the separation of your business assets and liabilities from your personal finances in most situations (gross negligence and bad faith being notable counterexamples). You must follow the ground rules, though, for being a corporation.

Why should you care about the separation of personal and business assets and liabilities? Suppose that your business is doing well, and you take out a bank loan to expand. Over the next few years, however, your business ends up in trouble. Before you know it, your company is losing money, and you’re forced to close up shop. If you can’t repay the bank loan because of your business failure, the bank shouldn’t be able to go after your personal assets if you’re incorporated, right?

Unfortunately, many small-business owners who need money find that bankers ask for personal guarantees, which would negate part of the liability protection that comes with incorporation. Additionally, if you play financial games with your company (such as shifting money out of the company in preparation for defaulting on a loan), a bank may legally be able to go after your personal assets. So you must adhere to a host of ground rules and protocols to prove to your state and the IRS that you’re running a bona fide company. For example, you need to keep corporate records and hold an annual meeting — even if it’s just with yourself!

A business can be sued if it mistreats an employee or if its product or service causes harm to a customer. But the owner’s personal assets should generally be protected when the company is incorporated and meets the other protocols for being a legitimate business just discussed.

Before you incorporate, investigate and find out what actions can cause you to be sued. You can do this by asking others in your line of business or advisors who work with companies like yours. Then see whether you can purchase insurance to protect against these potential liabilities. Insurance is potentially superior to incorporation because it pays claims.

If you belong to a professional group(s), especially if it has a national office, the group may be able to provide information on the percentage of members who are incorporated and on legal and insurance issues. Also, insurance agents may be able to advise on their experience with claims in your specific industry.

Suppose that you perform professional services but make a major mistake that costs someone a lot of money, or worse. Even if you’re incorporated, if someone sues you and wins, your company may have to pay a sizeable settlement. This situation not only costs a great deal of money but also can sink your business. Only insurance can cover such financially destructive claims.

You can also be sued if someone slips and breaks a bone or two. To cover these types of claims, you can purchase a property or premises liability policy from an insurer.

Accountants, doctors, and a number of other professionals can buy liability insurance. A good place to start searching for liability insurance is through the associations that exist for your profession. Even if you aren’t a current member, check out the associations anyway. You may be able to access any insurance they provide without membership or you can join the association long enough to get signed up. Incorporating, however, doesn’t necessarily preclude insuring yourself. Both incorporating and covering yourself with liability insurance may make sense in your case.

Corporations are taxed as entities separate from their individual owners. This situation can be both good and bad. Suppose that your business is doing well and making lots of money. If your business isn’t incorporated, all your company’s profits are taxed on your personal tax return in the year that you earn those profits.

If you intend to use the profits to reinvest in your business and expand, incorporating can appear to potentially save you some tax dollars. When your business is incorporated (as a regular or so-called C corporation ), effective 2018, all of your profits are taxed at the 21 percent corporate tax rate, which is lower than most of the individual income tax brackets for moderate and higher income earners.

But, there’s more to this tax rate comparison story. Unincorporated small businesses that operate as so-called pass-through entities (for example, sole proprietorships, LLCs, partnerships, and S corporations), named so because the profits of the business pass through to the owners and their personal income tax returns, have a new advantage. To address the fact that business owners that operated their business as a pass-through entity could face a higher personal federal income tax rate than the 21 percent rate levied on C-corporations, Congress provided a 20 percent deduction for those pass-through businesses. So, for example, if your sole proprietorship, LLC, partnership, or S-corporation netted you $80,000 in 2022 as a single taxpayer, that would push you into the 22 percent federal income tax bracket, a bit above the corporate rate of 21 percent. But, you get to deduct 20 percent of that $80,000 of income ($16,000), so you would only owe federal income tax on the remaining $64,000 ($80,000 – $16,000). Another way to look at this is that the business pass-through owner would only pay federal income taxes on 80 percent of his profits and would be in the 22 percent federal income tax bracket. This deduction effectively reduces the 22 percent federal income tax bracket to 17.6 percent, which is lower than the 21 percent corporate tax rate.

One caveat to the previous points: The 20 percent pass-through deduction gets phased out for service business owners (such as lawyers, doctors, real estate agents, consultants, and so on) at single taxpayer incomes above $170,050 (up to $220,050) and for married couples filing jointly incomes over $340,100 (up to $440,100). For other types of businesses above these income thresholds, this deduction may be limited so consult with your tax advisor.

Resist the temptation to incorporate just so you can leave your money in the corporation, which may be taxed at a lower rate than you’d pay on your personal income. Don’t be motivated by this seemingly short-term gain. If you want to pay yourself the profits in the future, you can end up paying more taxes. Why? Because you pay taxes first at the corporate tax rate in the year your company earns the money, and then you pay taxes again on these same profits (this time on your personal income tax return) when you pay yourself from the corporate till in the form of a dividend.