Jim Forrester, CPA
When it comes to securing your business status in the eyes of the Internal Revenue Service, nothing carries more weight than the initials “Inc.” Incorporation elevates you as an enterprise with a vision, one that plans to grow, flourish and pay your fair share of taxes for years to come. Not all corporations are big, but the word sure sounds big, doesn’t it?
Traders who operate as a corporation enjoy a number of corporate benefits, including personal asset protection, the maximum allowable business deductions (including 100% of your medical bills), and the ability to amortize pre-existing and start-up expenses and depreciate business assets.
The price for these corporate perks, of course, is double taxation; because a corporation is not a “flow-through” entity, it is taxed, albeit at a more favorable rate than individuals. Still, with a little tax planning, even the corporate tax bite can be minimized, making incorporation a very attractive entity for many traders.
How Incorporation Works
When you file articles of incorporation with your Secretary of State, you create a separate legal entity that has the power to enter into contracts, buy and sell real estate, sue and be sued, and even commit a crime. Like any other individual, a corporation also pays its own taxes; its shareholders (owners), board of directors (managers) and officers (who oversee day-to-day operations) are not responsible for corporate liabilities, though they may be held liable at the personal or positional level in instances of fraud or when personal services are rendered.
In most states, you can legally form a one-person corporation in which you function as sole director and officers, or you may include family members or other parties. But even (and especially) a one-person corporation must meet the minimum requirements of incorporation (holding and recording minutes of annual meetings; maintaining separate books and records; issuing stock to shareholders) to preserve your personal asset protection.
A C corporation designation refers to the standard, for-profit, state-formed entity as described above. An S corporation status, obtained by filing IRS Form 2553 and a similar form in some states, converts the C corporation into a flow-through entity whereby the corporation’s income flows through to the individual shareholders’ tax returns. Be aware, however, that this change in status also changes the deductibility rules; for instance, medical reimbursements cannot be deducted in an S corporation.
An S corporation designation must be filed by March 15 for calendar-year taxpayers for the election to take effect, except in the case of new corporations, which have 75 days from start of business. S corporation status has some additional provisions: all shareholders must be U.S. citizens or have U.S. resident status, the number of shareholders may not exceed 75, and the S corporation may only issue one class of stock.
Unlike limited partnerships and LLCs, a corporation can continue indefinitely; its existence is unaffected by the death or incapacity of its shareholders, directors or officers, or by the transfer of its shares.
Advantages of a C Corporation
A C corporation is a good selection for traders who want to grow their wealth by reinvesting their profits for the long haul instead of taking dividends (and a double tax hit) for short-term needs, as long as they are not too profitable and their accumulated retained earnings do not exceed $250,000.
One of the main advantages of a C corporation is that it has its own tax brackets, so that instead of your trading gains being taxed at your personal tax rate, the first $50,000 in profits from your C corporation are taxed at just 15%.
Here are other advantages of a C corporation:
-Personal asset protection.
-Maximum business deductions.
-Business losses: there is no limit on the amount of capital or operating losses that a corporation may carry back or forward; sole proprietors however cannot claim a capital loss greater than $3,000 without offsetting capital gains or electing the mark-to-market accounting method. However, a corporation must elect the mark-to-market accounting method to claim a current-year loss on trading activity.
-Income shifting: the ability to divide income between the corporation and the shareholders to minimize taxes. Not available to S corporations.
-Fringe benefits: corporations can offer greater contribution limits and flexibility in corporate retirement and medical plans than unincorporated entities. A corporation also can deduct 100% of its medical insurance premiums; under an LLC, the insurance deduction is subject to self-employment tax.
– Amortization of pre-existing and start-up expenses, the same as sole proprietorships and LLCs.
– Depreciation of business assets, same as sole proprietorships and LLCs.
– Leasing assets to the corporation: you may realize tax savings by leasing real property, a vehicle or even a domain name to your corporation.
Advantages of an S Corporation
An S corporation offers an additional advantage: self-employment tax savings. By electing the S corporate status, only the earnings actually paid out to you as salary are subject to payroll taxes; money left in the business is not subject to payroll taxes or self-employment tax. All income passes through, but its tax status depends on whether it is classified as salary or ordinary income.
Here’s an example: If you had net income of $60,000 and paid yourself $40,000 in salary, leaving $20,000 in the business, as a sole proprietor you would pay self-employment tax on the full $60,000 ($60,000 x 15.3% = $9,180). But as a corporation, you would only owe self-employment tax on the $40,000 in salary ($40,000 x 15.3% = $6,120), resulting in a savings of $3,060.
Disadvantages of Incorporating
There are two main disadvantages to incorporation: double taxation and corporate requirements.
Here’s how double taxation can sting you: A corporation is taxed on its profits. When profits are paid out in the form of dividends, they are taxed again to the recipient as dividend income at the individual’s income tax rate.
To work around this double tax, most small corporations pay few or no dividends. Instead, they pay salaries and fringe benefits to their owners, which are then deductible to the corporation.
Unfortunately, there is no easy way around the formalities of remaining in compliance with the general corporation law of your state. In most instances, you are required at a minimum to file formal articles of incorporation, elect a board of directors and appoint officers. You will be required to hold an annual meeting at least, and keep minutes of all meetings, as well as maintain separate corporate records and bookkeeping.
What sounds like a lot of work is actually pretty minimal when you consider that most trader corporations are one- or two-person entities. As long as you are willing to assign titles, hold a meeting or two and keep your records current, you can be your own corporation without undue hardship or paperwork.
Is incorporating right for every trader? Of course not; in the trading industry, there is no cookie-cutter, one-size-fits-all legal entity. Each trader is different, which is why it is important to seek the advice of the tax professionals at Traders Accounting before making any organizational decisions. We have the unique combination of tax expertise and comprehensive understanding of your unique status as a trader to help you make the decisions that are right for you.
While the benefits of trading as a legal entity are numerous, there is no one legal entity or structure that is right for everyone. A Traders Accounting ‘Tax Action Plan’ can help you determine if a limited liability company, a C corporation, or a combination of the two will most benefit your trading business.