Corporations are taxed as entities separate from their individual owners. This situation can be both good and bad. Suppose that your business is doing well and making lots of money. If your business isn’t incorporated, all your company’s profits are taxed on your personal tax return in the year that you earn those profits.
If you intend to use the profits to reinvest in your business and expand, incorporating can appear to potentially save you some tax dollars. When your business is incorporated (as a regular or so-called C corporation), effective 2018, all of your profits are taxed at the 21 percent corporate tax rate, which is lower than most of the individual income tax brackets for moderate and higher income earners.
But, there’s more to this tax rate comparison story. Unincorporated small businesses that operate as so-called pass-through entities (for example, sole proprietorships, LLCs, partnerships, and S corporations), named so because the profits of the business pass through to the owners and their personal income tax returns, have a new advantage. To address the fact that business owners that operated their business as a pass-through entity could face a higher personal federal income tax rate than the 21 percent rate levied on C-corporations, Congress provided a 20 percent deduction for those pass-through businesses. So, for example, if your sole proprietorship, LLC, partnership, or S-corporation netted you $80,000 in 2022 as a single taxpayer, that would push you into the 22 percent federal income tax bracket, a bit above the corporate rate of 21 percent. But, you get to deduct 20 percent of that $80,000 of income ($16,000), so you would only owe federal income tax on the remaining $64,000 ($80,000 – $16,000). Another way to look at this is that the business pass-through owner would only pay federal income taxes on 80 percent of his profits and would be in the 22 percent federal income tax bracket. This deduction effectively reduces the 22 percent federal income tax bracket to 17.6 percent, which is lower than the 21 percent corporate tax rate.
One caveat to the previous points: The 20 percent pass-through deduction gets phased out for service business owners (such as lawyers, doctors, real estate agents, consultants, and so on) at single taxpayer incomes above $170,050 (up to $220,050) and for married couples filing jointly incomes over $340,100 (up to $440,100). For other types of businesses above these income thresholds, this deduction may be limited so consult with your tax advisor.
Another possible tax advantage for a corporation is that corporations can pay, on a tax-deductible basis, for employee benefits such as health insurance, long-term-care insurance, disability insurance, and up to $50,000 of term life insurance. The owner usually is treated as an employee for benefits purposes. (See the later section “Benefits that are deductible for corporation owners” for details.) Sole proprietorships and other unincorporated businesses usually can take only tax deductions for these benefit expenses for employees. Benefit expenses for owners who work in the business aren’t deductible, except for pension contributions and health insurance, which you can deduct on the front of IRS Form 1040.
Another reason not to incorporate, especially in the early years of a business, is that you can’t claim the losses for an incorporated business on your personal tax return. On your business tax return, you have to wait to claim the losses against profits. Because most companies produce little revenue in their early years and have all sorts of start-up expenditures, losses are common.
Examining other incorporation considerations
Because corporations are legal entities distinct from their owners, corporations offer other features and benefits that a sole proprietorship or partnership doesn’t. For example, corporations have shareholders who own a piece or percentage of the company. These shares can be sold or transferred to other owners, subject to any restrictions in the shareholders’ agreement.
SHOULD YOU INCORPORATE IN DELAWARE, NEVADA, OR WYOMING?
Some states are magnets for incorporation. The reason is simple: Select states, such as Delaware, Nevada, and Wyoming, make incorporation easier and less costly, and they tax corporations at a much lower rate than other states. Some states also allow you to do other things, such as keep the identity of your shareholders out of public view.
So should you rush out and incorporate in one of these corporate-friendly states if you live in one of the other 47 states? The answer is probably not. The reason is that the state in which you operate your company probably also requires you to register your corporation and pay the appropriate fees and taxes.
You should also consider the fact that some folks with whom you do business may be puzzled or concerned by your out-of-state incorporation. If you’re considering incorporating out of state, you should definitely consult with an experienced small-business legal advisor and tax advisor.
Corporations also offer continuity of life, which simply means that corporations can continue to exist despite the death of an owner or the owner’s transfer of their share (stock) in the company.
Knowing where to get advice
If you’re totally confused about whether to incorporate because your business is undergoing major financial changes, getting competent professional help is worth the money. The hard part is knowing where to turn because finding one advisor who can put all the pieces of the puzzle together can be challenging. And be aware that you may get wrong or biased advice.
One step further: S corporations
Subchapter S corporations, so named for that part of the tax code that establishes them, offer some business owners the best of both worlds. You get the liability protection that comes with being incorporated as with a C corporation, and the business profit or loss passes through to the owner’s personal tax returns (like in a sole proprietorship). In this section, I discuss the tax specifics of using S corporation status and the requirements for S corporations.
S corporation tax specifics
An S corporation is known as a pass-through entity for tax purposes. This simply means that the income that the company earns passes through to the company’s