Raoul The Taxman: "Should I Incorporate?"

by Raoul

"So here's the deal, Raoul" asks another RAP member, "my free-lance business has really picked up, and blah blah blah...should I incorporate?" A familiar inquiry. Raoul has heard it many times in his illustrious career.

So, you just picked up the neighborhood bungee jumping business as a client, got a Tascam DA-88 for the home studio, and came up with a snappy trade name to call yourself. Naturally, the next step is to form a corporation. And if that is what you do, before getting some decent advice, junk the snappy trade name and call yourself Bozo. There are a lot more reasons not to incorporate than there are to do so. And we're gonna get into them but, first, a related Raoul Junior Tax Buddy true life adventure.

A few years ago, I called one of my clients and was surprised to hear the voice on the other end of the telephone say "Blanking Blank, Inc.." Well, all Raoul could say when my client came on the line was, "Man, what the hell have you done?" He told me, and all I can say is, not even Raoul could make up a story like this. Here it is.

Apparently, several weeks before, he had met an (alleged) lawyer in a titty bar. After a few drinks, my client got into discussing the exceptional growth of his consulting business, and in turn, the young lawyer advertised his ability. By the time they finished trying to impress each other, my client had decided to incorporate his personal service business. Readers, remember that term, "personal service."

My friend said that the deciding factor was when the lawyer told him that a corporate structure would limit his liability. My client interpreted this to mean that he could not be sued. Which, to my disbelief, the lawyer confirmed! My response to him was this. Go back to the titty bar, find the lawyer, and tell him that you have some business for him. You want to sue someone, but, unfortunately, they are incorporated. Will the lawyer sue him anyway? Well, of course! One thing has nothing to do with the other.

In addition, I explained to my client that now, instead of him having to file one tax return per year as an individual, he would in the future be required to file four quarterly federal payroll tax returns, one annual federal payroll tax return, four quarterly state income tax returns, one annual state income tax recap, four quarterly state unemployment tax returns, a year-end report to the Social Security Administration, a federal corporation income tax return, and a state corporation income tax return. Fully seventeen additional tax forms, at least! And, he would still have to file his individual tax return.

Now don't get Raoul wrong. I am not corpo-phobic. If there was no need for corporations, they would be less likely to exist in any form.

But where and when did all this corporate charisma start? Is there any basis in fact, and, if so, why? This calls for a history lesson. Many years ago, it was extremely attractive for certain individuals to incorporate themselves, particularly those in the service business, including not only people like yourselves, but doctors, attorneys, accountants, architects, etc.. Here's a partial list of some of the advantages one could cop to in a corporate structure:

1. It was possible to put your corporation into bankruptcy while insulating yourself, or visa versa. In fact, in some respects, it still is.

2. Since at one time corporate tax rates were as low as fifteen percent on the first $50,000 of net income, you were able to juggle your income between the two entities, thereby accumulating a greater return after taxes, and subsequently, use the accumulated wealth in your corporation to provide such benefits as securing personal loans, acquiring personal assets, etc..

3. A principle stockholder/officer could pay themselves rent from the corporation, just up the level to be deductible by the corporation, but not taxable to the individual.

4. You were able to close a corporation's year on a fiscal. (Meaning that your corporate year could end in a different month than the tax law provides for individuals.) This allowed for the totally cool maneuver of accruing (deducting, but not paying) a bonus to yourself at the end of the corporation's year, but not paying it to yourself until the start of your own tax year. If your timing was right, this facilitated the deferral of taxes for almost one and a half years.

5. And two of Raoul's particular favorites. The corporation could even own a ride, which you could occasionally (uh-huh) use on business. Tax free!

6. And, pay medical expenses of officer/employees as a nontaxable benefit.

As Mel Brooks said, "It's good to be the King." Unfortunately, most of those "goodies" were addressed, and compromised, in what you have heard Raoul refer to as "El Stinko Grande," The Internal Revenue Code of 1984. It would just be a waste of space to make a list of things you can not do now, which would be almost the exact opposite of the selection of the items above. Suffice it to say, in regard to folks like us who provide services incorporating, "th..th..th..that's all folks!" Effectively, you can pretty much eliminate the preceding list. There are, however, a few key areas that warrant further discussion.

This is one area where the term "tax simplification" was true to its word. By eliminating several obvious, unfair advantages and making it less attractive to be a corporation, the congress allowed many people the opportunity to un-complicate their lives. In fact, for the last several years, many professionals have been systematically un-incorporating some of their clients, especially those who were required to become personal service corporations under the 1984 revenue code. Raoul thinks this is okay. here's why.

First of all, with the limiting of a considerable amount of the attractiveness, the corporation, especially for individuals, became less cost effective. The additional costs of maintaining a corporation were, in many cases, no longer justified. And concurrently, we are now allowed to do some of the same things as individuals who were previously available to corporations, such as establishing pension/profit-sharing plans, taking advantage of increased "bonus" depreciation, etc..

Second, the advent of the personal service corporation (which basically encompasses all individuals who provide a service) actually costs its incorporators higher taxes. A flat rate was established, currently thirty-six percent, on every dollar of net corporate income.

So, what is the object lesson in all this you ask? Raoul says, "never act on free advice that you get in a titty bar!

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