Advantages to Incorporating a Business

The purpose of this letter is to explain, in general, the advantages that may result from the incorporation of a business. As you know, it is possible to conduct business as a sole proprietorship or a partnership. However, we feel that the advantages of incorporation are such that you may wish to consider conducting your business in the corporate form.

Generally, the advantages of incorporation are as follows:

1. Limited Liability. A corporation is treated as an entity separate from its owners. This "separate entity" concept results in insulation of the owners from liability for corporate debts. The amount of risk is never more than the owners' investment in the corporation. Although the directors and shareholders of a corporation have the responsibility of insuring that there is adequate capital in the corporation, they can protect their personal estates against claims arising from business operations by prudent and responsible business planning. However, this concept does not protect a shareholder, who is an employee of the corporation, from liability for his own negligence or the negligence of another employee acting as his agent, pursuant to the general principles of negligence law.

2. Continuity. Unlike a sole proprietorship or partnership, a corporation continues in existence in the event of death of one of its shareholders. Therefore, although the death of one of the shareholders may result in a loss to the corporation of that person's skills or expertise, the corporation may continue its business, without interruption, upon said death.

3. Central Management. The business of the corporation is handled by its officers who are elected by and given direction by the board of directors or a committee appointed by the board of directors. Therefore, certain responsibilities can be delegated to individuals, who may act on behalf of the corporation, thereby preventing duplication of effort and providing more time for each individual to perform his duties.

4. Transferability of Interests. Since ownership in a corporation is evidenced by stock certificates, that interest can be transferred merely by transferring or assigning the stock certificate. Furthermore, the corporation and its shareholders may enter into a stock purchase agreement which provides for restrictions on who may purchase the stock, requirements that the stock be offered for sale to the corporation or the other shareholders upon the occurrence of certain events, or otherwise limit or compel the disposition of the stock.

5. Tax Advantages. Additionally, there are several tax advantages to the corporation form of doing business:

(a) The corporation is a separate entity for tax purposes and, therefore, it is taxed on its income at special corporate income tax rates, which generally range from 15% to 38%. However, compensation can be paid to the employees and taken as a deduction by the corporation which results in a situation where the employee pays income tax only on the amount of compensation he is paid, regardless of the amount of profit made by the corporation. There are limits on the amount of capital which corporations may retain, as opposed to paying dividends to its shareholders. However, proper tax and business planning can result in aggregate lower income tax liabilities.

(b) Pursuant to Internal Revenue Code Section 351, a sole proprietorship or a partnership may transfer its assets to a newly-formed corporation without gain or loss being recognized by the individual transferors if certain requirements are met.

(c) Pursuant to Internal Revenue Code Section 1244, the shareholders of a newly-formed corporation may issue stock in such a manner that, in the event of a realized loss in the value of the stock, said loss can be deducted in full against the shareholder's ordinary income, rather than being treated as a capital loss. Of course, there are certain requirements which must be met, as well as certain dollar limitations.

(d) Pursuant to the Internal Revenue Code sections relating to Subchapter S elections, the corporation may elect to be taxed as a Subchapter S corporation if it meets certain requirements. Said election results in the income or loss from the corporation's business being taxed directly to the shareholders in a similar manner to a partnership. This may be a useful tool when it is possible that a loss or substantial investment tax credit may result in the first years of business.

Additionally, there are several advantages of incorporation which apply to all corporations but are particularly useful to professional service corporations. In general, these advantages result in the corporation being able to pay certain expenses on behalf of a shareholder with pre-tax dollars, rather than having the individual shareholder receiving income, paying tax on that income, and then paying the expenses with his after-tax income. The advantages are as follows:

1. Qualified Plans. A corporation may establish a qualified savings and profit sharing and/or pension plan. The use of these plans permits a shareholder to defer a higher percentage of his income until later years than is permitted under Keogh plans. A corporation can contribute certain amounts to either or both of said plans and the shareholder will not be taxed on the amounts contributed until he actually receives them. Therefore, a tax savings will result if the contributions are not received by the shareholder until retirement when he is generally in a lower income tax bracket. Additionally, these plans may classify employees into different groups and provide for a different rate of contribution on behalf of each group.

2. Medical Expense Reimbursement Plans. A corporation may contribute to a medical expense reimbursement plan, or reimburse employees pursuant to a medical expense reimbursement plan, for medical expenses incurred by the employees and, in some instances, their families. The contributions, reimbursements and/or insurance premiums which are paid are tax deductible by the corporation and are not included in the income of the employee. However, the beneficial use of this type of plan has been limited somewhat by the Revenue Act of 1978. Important standards regarding the classification of employees have been imposed in order to ensure that key employees are not treated more favorably than other employees. The previous rules for plans which are funded by outside insurers remain unchanged.

3. Disability Income Plans. Pursuant to a disability income plan, a corporation may purchase disability insurance for its employees and deduct the cost of the premiums from its income. Furthermore, the premiums will not be taxed as income to the employee.

4. Group Term Life Insurance. A corporation may purchase up to Fifty Thousand Dollars ($50,000.00) of group term life insurance and deduct the cost of the premiums from its income. Furthermore, the premiums will not be t axed as income to the employee.

5. Death Benefits. Pursuant to the Internal Revenue Code, a corporation may pay up to Five Thousand Dollars ($5,000.00) in death benefits to the beneficiaries of an employee. The payment is not income to the beneficiary and is deductible by the corporation.

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Although the law requires a corporation to comply with certain formalities, the tax and non-tax advantages that can be gained from incorporating, in many cases, may make a corporation a desirable form of conducting business.

We hope that this discussion will help you understand the desirability of conducting a business in the corporate form.