42. Incorporation

To incorporate or not to incorporate, that is the question. The answer is not always clear. There is no magic level of income or profits at which you should or should not incorporate. The decision lingers on many legal, tax, and financial aspects - including: What is the current level of profits, how much income is taken for personal use, how much is
put back into the business, and what are the long range planning objectives?

Non-Tax Factors:

Limited liability--this is probably the primary nontax reason for incorporating. In a proprietorship or general partnership, the proprietor or partners are fully and personally liable for all of the business debts and liabilities, contract and tort. With a corporation, the stockholders, even sole stockholders, are not personally liable for corporate acts or
debts.

Transferability of shares--this is probably the second most important nontax reason for incorporating. It is simply easier to split up a corporation into a number of shares to be given to other family members for estate planning purposes than to make gifts of partial interests in land, assets or a partnership. It is also easier to divide the ownership of the business into the percentages of stock ownership required for proper planning.

Voting, nonvoting and preferred stock--a large part of the advantage of incorporating is the use of various classifications of stock (especially in family estate planning situations) to restrict or freeze an individual's interest or to shift control and/or participation in growth from one individual to another. Bonds may also be used for these purposes. In addition, restrictions on the transferability of any stock, such as first option or stock redemption agreements, may be utilized.

Unlimited life--another favorable factor is that a corporation is separate and distinct from its owners and therefore is not legally affected by the death, disability, retirement or withdrawal of a stockholder so the business can continue without interruption.

Tax Factor:

Separate taxable entity--a corporation is a separate entity for tax purposes, unlike a proprietorship or partnership in which the profits are taxable to the owners. This separate tax treatment can be a substantial advantage since the corporate tax may be much less and the total business income can be split between the corporation (as profits) and the owners (as salary).

*For example the federal income tax on corporate profits is:

-----------------Taxable Income---------------Tax Rate

---------------0----------- $25,000---------------15%
---------------$25,000----- $50,000---------------18%
---------------$50,000------$75,000---------------30%
---------------$75,000----- $100,000--------------40%
-------------------------over $100,000------------46%

If the business earned $50,000, one might withdraw half as salary, on which the personal income tax would be $3,760 for profit, the corporation would pay a corporate tax of $3,750. That is a combined tax of $7,510. If
one did not incorporate the business, the personal income tax would have been $12,014. Thus, the use of a corporation would save $4,504 in taxes this year.

It is not enough to look at only the immediate tax advantage. One must also consider the tax, if any, upon a later distribution of corporate profits as a dividend, as salary, as retirement income, or as a capital gain on the sale, liquidation or redemption of the ownership interest.

Generally the corporate form of ownership will be more favorable to other forms when:

The Business is Profitable
The Business is Growing
Profits are Reinvested in the Business
The Business Will Continue Indefinitely

The separate and lower tax status of a corporation may also be used to accumulate earnings at a lower tax cost. A corporation is allowed to accumulate up to $150,000 of surplus for any reason without incurring a
penalty.

Other Factors to Consider

A corporation is often used advantageously to provide key man insurance, split dollar insurance, and non-qualified deferred compensation plans for owners and key people.

A corporation can also pay the estate taxes and the administrative costs of a deceased stockholder by means of a section 302 or a section 303 redemption.

There are a number of special tax deductible benefit plans which a corporation may implement for its officer/stockholders. A Qualified Pension and/or Profit Sharing Plan. Plan contributions of 25% or more of compensation are deductible and grow income tax free. Death benefits can be distributed free of estate taxes. Favorable ten-year
averaging on lump sum pay outs is available.

The corporation can buy long term disability income for its officers. The premiums are tax deductible to the corporation and not taxable to the insured. Up to $5,200 of benefit payments may be received tax free by the
insured in the event of a disability.

Tax deductible group term or permanent life insurance might also be available on a fully or partially tax free basis to the insured.

The full premium for hospitalization and major medical insurance is deductible and the corporation could pay for any medical expenses not covered by insurance by installing a medical reimbursement form.

Tax reference verification 1-800-829-1040

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