Incorporation Tax Myths

Document Sample
Incorporation Tax Myths Powered By Docstoc
					?Almost once a week my CPA office gets the call from some new business owner
looking for an accountant. Usually, after a bit of hemming and hawing, the caller gets
up the courage to ask about something he's only heard rumors about--those
semi-secret ways one can eliminate taxes by incorporating.

I always try to be friendly as this conversation unfolds. Hey, I know the score. This
entrepreneurial newbie has at some point in the past heard and then believed one or
more of the urban tax myths about how corporations save small businesses tax.

Now make no mistake: Incorporation can be an excellent business decision.
Incorporating a business always reduces the business owner's legal liability at least a
little bit. And incorporating a business can sometimes reduce some of the taxes a
business pays (such as payroll taxes). But incorporation doesn't absolve a business or
its owner from paying income taxes. In particular, entrepreneurs and business people
should not fall for three urban myths about taxes...

Incorporation Tax Myth #1: Extra Tax Deductions

The most common tax myth may just be that by incorporating, a business owner
receives extra tax deductions. Like many myths, there's a grain of truth here. But
business owners should know that, for the most part, tax laws allow a business to
deduct any ordinary or necessary expense.

The definition of what's "ordinary and necessary" doesn't change because one
business operates as a corporation or another business operates as a sole

For example, a small business operating as a sole proprietorship doesn't get to deduct
extra amounts or personal expenditures merely because the proprietor incorporates.

And that means you shouldn't incorporate a new or ongoing venture on the basis of
the "extra deductions" myth.

Incorporation Tax Myth #2: Avoiding State Income Taxes

Many entrepreneurs in high tax states want to believe another common myth... the
myth that incorporating in another low-tax or no-tax state will save taxes. Some
California businesses want to believe that incorporating in Nevada means the business
doesn't have to pay California taxes.

One understands the source of this myth. A Nevada corporation operating in Nevada
doesn't have to pay state income taxes. Yet a California corporation operating in
California does have to pay state income taxes. Why can't a California entrepreneur
incorporate his business in Nevada? Won't that allow the business to avoid California
state income taxes?

Unfortunately, no.

Here's why: The state of incorporation doesn't determine which state's tax laws apply.
What matters is the state or states in which a business operates. For example, if a
Nevada corporation operates 100% in California, California gets to tax 100% of the
income earned by the Nevada corporation. Similarly, if a California corporation
operates entirely in Nevada, California doesn't get to tax the income earned by the
corporation. Nevada does--or could if it wanted.

The bottom-line? You should not incorporate in another state as a way to save state
income taxes. The technique doesn't work.

Note: Another related technique does work and deserves mention: You can move your
business to a low-tax state, begin operating from that state, and then save state income
taxes that way.

Incorporation Tax Myth #3: Sheltering Income from Taxes

One final and somewhat odd myth about incorporation deserves busting...

Some new business owners understand that if a corporation earns profit but doesn't
pay out that profit to the shareholders, the shareholders don't have to pay income taxes.
This bit of trivia sometimes triggers the idea that maybe a shareholder can shelter
income by "leaving" cash inside the corporation.

What this myth gets wrong is that while a business owner can avoid personal income
taxes by leaving profits inside the corporation, the corporation then gets taxed on
those profits. In this case, the business owner hasn't really reduced the taxes levied on
his or her entrepreneurial activities. Rather, he or she has in effect written the check
from a different bank account.

And another facet of using a corporation to shelter income from taxes should be
mentioned. When the shareholder moves the money out of the corporation, he or she
will pay taxes on the dividends. When one combines the corporate income taxes paid
by leaving money in the corporation and the later dividends tax paid by the individual,
the pursuing incorporation myth #3 may actually cost the entrepreneur more in taxes.


Tax accountant Stephen L. Nelson specializes in saving taxes for businesses and their
owners. Nelson is also the author of downloadable do-it-yourself ebooks for
Incorporating in Florida and Setting Up a Texas Corporation.