Incorporation Blunders: Tax Mistakes No Business Owner Wants to Make - By: Stephen Nelson

Small business incorporation usually generates significant benefits. Often, the business and its owners save taxes. And in many situations, shareholders reduce their legal liability.

In spite of all the great benefits of small business incorporation, however, all too often small business owners find the decision to be painful and expensive because they make one or more tax mistakes. And that's too bad. One can sidestep the mistakes by knowing what they are...

Incorporation Tax Mistake #1: Incorporating When an LLC Would Do Just as Well

Many small business owners don't realize that a limited liability company provides just as good of liability protection as a regular, old-style corporation. In addition, an LLC keeps the business owner's tax accounting simpler in many situations.

Accordingly, one of the most common (and sometimes most expensive) incorporation mistakes is using a regular corporation rather than a simpler, cleaner limited liability company.

The lesson here is simple: If you're starting a new business, consider the limited liability company option. By using an LLC, you may be able to save yourself tons of aggravation.

Incorporation Tax Mistake #2: Forgetting to Pay the Owner a Salary

Small business corporations operated by the owner need to pay their owner a salary. That's the rule. But then there's the rub.

Payroll accounting takes time. Payroll taxes cost money. And, frankly, the whole employee payroll process is just an enormous headache.

Predictably, then, many small business corporations just forget or skip doing payroll for their shareholder-employees. This isn't a mistake you want to make, however. When (not if) the Internal Revenue Service catches up with the business, the corporation and the shareholder-employees will all be penalized. Ouch.

Incorporation Tax Mistake #3: Forgetting to Do Quarterly Tax Deposits

Operating a small business as a regular corporation, known as a C corporation, means that the corporation itself may owe income taxes to the federal or state government. When taxes are due, the corporation must estimate and then deposit quarterly tax payments.

Note that these quarterly payments (due April 15, June 15, September 15, and January 15) are definitely not complicated to make. The payments, however, are easy to forget...

Incorporation Tax Mistake #4: Ignoring C Corporation Tax Loopholes

Unlike sole proprietorships, partnerships and S corporations, C corporations provide some interesting and unique fringe benefit tax loopholes for shareholder-employees including gold-plated health insurance and even tax-free housing.

Small C corporations, accordingly, should explore these "approved-by-Congress" loopholes. The annual tax savings can easily add up to thousands of dollars.

Note: A C corporation is just a regular corporation that has not made the special election required to be treated as an S corporation. If a corporation files an annual federal 1120 tax return, the corporation is a C corporation.

Incorporation Tax Mistake #5: Not Looking at Subchapter S Corporation Status

Most corporations in the United States make an election to be treated as a Subchapter S corporation rather than accepting the default tax classification (which is C corporation tax treatment).

Which begs the question, "Why?" And here's the answer: If a corporation is owned by one hundred or fewer US citizens or permanent residents, the corporation can elect Subchapter S corporation status and then minimize both corporate income taxes and payroll taxes on shareholder-employee wages.

Some accountants and tax preparers don't like S corporations because the S corporation 1120S tax return can be a little more complicated to prepare. And this dislike can tend to affect the advice they offer their clients. But small business corporations should generally at least look at the S corporation option. The annual tax savings can amount to several thousand dollars for each shareholder-employee. Yikes.

Incorporation Tax Mistake #6: Putting Investments Inside the Corporation

A final incorporation mistake should be mentioned. Entrepreneurs often like to store investments inside their corporations--sometimes for reasons of convenience or easy control. But storing real estate, stocks, and other investments inside a corporation creates problems and causes the business owner to bear additional tax risks.

Without going into all the nitty-gritty details, storing investment assets inside a corporation may mean paying a higher capital gains tax (even if the corporation is an S corporation). And storing investment assets inside a corporation may trigger early payment of capital gains.

The bottomline? Small business owners should typically store their investment wealth outside of their business corporations.

Incorporating a small business can save the business owners thousands of dollars annually in taxes. But in order to safely harvest those tax savings, the corporation needs to avoid some common mistakes.

Business tax accountant and Quicken for Dummies author Stephen L. Nelson serves small businesses and their owners in the Seattle area. Nelson is also the author of the Incorporation Kits and Limited Liability Company Kits web sites.