Tax & Business Insights


Reasons for Incorporating

Volume 7 Issue 5 -- September/October 1995

In the last edition of this newsletter we talked about limiting liability as a reason for incorporating. This edition explores some of the tax and other reasons for incorporating.

Early in this century, it was commonly believed that only large businesses like factories and mills were incorporated. These large and often successful corporations provided benefits, such as retirement plans, medical care, and insurance, often for management only, that small businesses did not offer.

Beginning in the 1950's, successful sole proprietors and partners, such as consultants, lawyers, and doctors, began to compare their compensation and taxes to those of executives of large incorporated entities. It became clear that something was amiss.

The "something" was corporate tax breaks for retirement plans, medical plans, and insurance benefits and the like. Such benefits were both deductible by the corporation and usually not included in the pay of corporate employees (or the tax was delayed until retirement).

Why, many sole proprietors and partners wondered, can't we incorporate and enjoy the same types of corporate benefits? Beginning in the early 1960's and up until the early 1980's, many small businesses did just that, incorporate. By the early 1970's, the tax reasons for incorporating were so compelling that most highly compensated professionals and other small businesses were incorporated.

As the scales tipped more and more in favor of incorporated small businesses, Congress began to give greater concern to IRS protests about the abuses of corporate benefit plans.

For example, it was possible until about 1978 to have a self-funded corporate medical plan for employees that allowed the corporation to deduct all medical expenses for its employees. What irritated some was the definition of "employee" in such corporate plans.

For example, in a small electrical contracting firm, "employee" could be defined as "a licensed electrician who is an officer of the corporation." Since many small firms had only one licensed electrician, the president and owner, that one person was the only one covered. Congress felt that such plans discriminated unfairly against most employees and passed new anti-discrimination tax laws.

Congress Curtails the Benefits

Over time, Congress killed, or greatly impaired, nearly all of the tax-favored fringe benefits. For example, it imposed discrimination tests which required that designated percentages of full-time employees be covered before top management could receive a tax deductible benefit. In other words, the owners and management could not use tax-favored programs to benefit primarily themselves.

In addition, many of the retirement and other benefit plans previously available only to corporate entities were extended on similar terms to partnerships and sole proprietorships.

Before, in the 1960's and 1970's, professionals (and others) had to incorporate to benefit from the more favorable retirement plans, now they do not have to incorporate. In other words, we now have substantial parity among the entities when it comes to choosing tax deductible fringe benefits.

In 1986, Congress expanded the "double tax" on corporations. Corporate profits and other types of gains are taxed twice, once at the corporate level and then again when the amount is distributed (less corporate tax) to the individual shareholder. Moreover, corporate tax rates were raised above some individual marginal tax rate brackets.

While the double tax bite can be eliminated (or mitigated) by electing "S" status for closely held corporations, these changes greatly reduced the need and tax advantages of incorporation. In essence, Congress neutralized the tax reasons for incorporating.

Non-Income Tax Considerations

Apart from tax considerations and the desire to limit liability, there are several reasons for incorporating.

Appearance is one reason. Quite frequently, if a person starting a new business has worked only in a large corporate environment, there is a tendency to desire a "corporate" title, like "president," or " CEO." While this title may seem superfluous, in some cases it is understandable if the entity from whom business is sought expects to deal with "titled" executives.

Another reason for incorporating is the protection of the entity purchasing the services. Let's say, your corporation regularly retains a number of free-lance computer programmers as independent contractors.

If a purported "independent contractor" is reclassified by the IRS as an "employee," the results visited upon the newly christened employer will be expensive. If individuals providing consulting services are incorporated, it is less likely that the IRS or state agencies collecting withholding or unemployment taxes can successfully reclassify them as "employees."

To lessen this exposure, some companies now require that self-employed individuals incorporate before services are performed.



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