Incorporation Tax and Filing Myths

Since posting the “Should I Incorporate?” article, some have brought up issues that fall into the realm of myths. It is important to note that entire industries have sprung up around servicing small businesses, including CPAs, HR professionals, financial planners, payroll services and so on. Some of these professionals greatly overstate the risks as a form of demand creation. Marketing professionals refer to this strategy as “Fear, Uncertainty and Doubt”, or FUD. A lot of what we’re going to be talking about on this site is to deliberately attack FUD, so that you can see the underlying issues that you need to understand in order to run a successful small business. Although our focus is on more high-tech businesses, many other business types can use a lot of the information you’ll find here.

Let’s jump right into some of the more common myths regarding taxation and annual filings, and remove some of the FUD involved.

Myth: Incorporating, especially as a C corporation, causes profits to be double-taxed.

False. Double taxation is the idea that first a corporation gets taxed on profits, and then when those profits are paid out as dividends to the shareholders, they are taxed again when the shareholders file their individual taxes. This part is true enough, but what is false is the implication that dividends are the only route to compensation for the owners of a small corporation. Usually, the shareholders and key employees are the same people. So, a proper use of excess revenue (within limits, see below) is to convert that into more payroll for the shareholder owners. Since payroll is pre-tax, pre-profit money, the corporation never pays tax on that in the first place. One tax, and only on the pay of the owner-employees.

Update: a reader sends the following critique, from an article in the Journal of Accountancy:

First, closely held C corporations are examined to determine whether they have overpaid their shareholder-employees. These corporations are allowed to deduct only “reasonable” compensation paid to shareholder-employees. So, examiners are looking for a disguised dividend, which is corporate profit being treated as compensation. Since a dividend is not deductible, but compensation is, the IRS may treat the portion of the compensation that it considers excessive as a dividend. The result is that the corporation loses its deduction for that amount and is assessed tax, interest, and penalties on the resulting increase in income.

Absolutely true. However, the articles on this blog are written to assist new business owners in getting their businesses running. In those years, the owners may wind up paying their other employees and deferring some or all of their own pay. Later in that same article that author recognizes this catch-up pay situation for C corporations:

If a business owner is underpaid when cash flow is weak, he or she may be entitled to catch-up pay later. For an example, see Choate Construction Co., T.C. Memo 1997-495, in which the Tax Court upheld as reasonable pay of more than $1 million when business improved after the first two years of operations.

If you find yourself in a situation where you need to decide how to split up revenue between salary, bonuses and dividends, and there are that many zeroes involved, then that is the kind of problem you want to have. There are many rules and guidelines regarding bonuses, and that article is a good read for a lot of that. But first, you have to get to the point of having to figure out what to do with all the money. You also have to have a firm grasp on the cash flow each month, and not expect to hand it all over to a CPA at the end of the year to make it all work out. We’re going to show you some ways to get control of that data in future articles.

Interestingly, between those two quotes in the same article, is this one regarding S corporations:

Conversely, S corporations are audited to determine whether they have underpaid their shareholder-employees. These shareholders may have set their own pay levels unreasonably low and simultaneously increased their profit distributions.

The same flexibility that a C corp can use to get business going could look suspicious for an S corp owner.

Myth: Using a CPA or other tax professional protects me from an audit.

False. You, the taxpayer, whether as an individual or a stakeholder in any business entity, are solely responsible for the results of your filings. Misconduct or negligence by a CPA or other paid preparer may allow you to sue them for damages, but chances are you’ll have to sign a waiver to get them to do your taxes for you. Pro tip: interview some CPAs, and ask them if any of their clients have been audited, and if so, what were the assessments against them. If these numbers are greater than zero, ask the CPA what portions of these amounts they covered for their clients, who relied upon their expert advice.

Myth: Not using a CPA will trigger an audit.

False. We have been preparing our own taxes individually for almost forty years, including decades of very complex business relationships, and for our own companies for about two decades. Our history of audits is no different than the statistical expectation for audits.

Myth: Being audited can destroy your business.

False. We have been subjected to document audits by the IRS several times, and each time it was resolved by either checking some boxes on a pre-printed form, or by sending in some substantiating records. We have been audited by the state a couple of times, same result. We were audited by the county once, and had even made a couple of mistakes on that one, but rather than getting raked over the coals, their auditor sent a nice letter thanking us for our assistance during his site visit. On some occasions we have received checks as the result of an audit.

Myth: You need to hire an attorney to incorporate.

False. Many states have excellent online systems that make it easier than ever to incorporate without an attorney. We’ll walk through these steps for Georgia in an upcoming article.

Myth: It costs a lot of money to incorporate.

False. Even with an attorney, $500 would be reasonable, but without an attorney (in Georgia) it costs much less than that.

Myth: It costs a lot of money in mandatory annual registrations to remain incorporated.

False. In Georgia, the annual registration fee is $50 (for-profit corporations of either type as well as LLCs) and can be paid online quickly with a credit card. Your state may be different.

Myth: You have to manage much more data and records when you incorporate.

False. No matter what business format you choose, you will still have to manage the same data and records, and report them in some form or another. The major difference is on what forms that data is reported. Many future articles on this blog will drill into that data and how to handle it efficiently.

Myth: For a small business, an S corp is the clearly better choice.

False. A C corp has a bright dividing line between business and individual finances, plus has a greater client cachet. Accountants love S corps and LLCs because they result in a greatly more complex individual return, and thus greater potential preparation fees, while a C corp may result in a moderately complex corporate return plus a vastly simpler individual return, both of which are within the grasp of the taxpayers themselves.

Myth: An accountant knows how my business runs better than I do.

False. If you run a cookie-cutter business such as a nail salon or used car lot, then yes, an accountant familiar with that type of business may know more than you about how that type of business should file its taxes, at least at first. However, if your business strays outside the norm of your industry in the slightest (welcome to the new economy), then you will very quickly outstrip your accountant’s expertise in those niches.

Myth: I can give my accountant a big box of files and receipts and he will then sort it all out for me.

False. If you are willing to pay enough for that service, then yes, that can be done. But in most cases you will have to collect and organize all that information first anyway, and then hand it over. If you have to do all that work anyway, you might as well understand the regulations and forms for yourself.

Again, nothing on this site is to be considered legal or financial planning advice. If you feel you cannot manage your business without an attorney or financial professional, then by all means, hire them. Our goal is to give you more facts, and our experience, including mistakes, upon which to base this decision. If you decide to go into business for yourself, then you are going to have to take responsibility for learning all aspects of that business, including applicable tax regulations and periodic filing. There is simply no substitute for becoming fully informed.

Author: Tom Baugh

Tom Baugh is the founder of SoftBaugh.

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