TurboTax / Tax Calculators & Tips / All Tax Guides / Small Business Taxes / Tax Advantages to Incorporating

Tax Advantages to Incorporating

Updated for Tax Year 2014


To be successful and hold the line financially, however, tax experts agree that even the smallest of businesses may benefit by incorporating.

Unincorporated businesses may be missing out on tax breaks

In the eyes of many small business owners, the corporate world is the realm of massive conglomerates such as Microsoft and General Motors. To be successful and hold the line financially, however, tax experts agree that even the smallest of businesses may benefit by incorporating.

An S corporation, as defined by the Internal Revenue Service, must be a domestic corporation that consists of no more than 100 "allowable shareholders" — including individuals, certain trusts and estates. It may not include partnerships, other corporations or non-resident alien shareholders. It may offer only one class of stock. S corporation rules require the shareholder employees are paid wages on a Form W-2 and the corporation is liable for payroll taxes.

C corporations, also known as general corporations, have no restrictions on the number of shareholders. The website Active Filings explains that corporations identified with large public stock offerings typically are C corporations. It notes that each shareholder's personal liability is normally defined by the amount of his investment.

"A Limited Liability Company (LLC)," the IRS website explains, "is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation." An LLC can be classified as an S corporation or as a partnership for income tax purposes. If the LLC is taxed as a partnership, the income from Schedule K-1 is shown on Schedule E and is not subject to self employment taxes.

“New businesses are not usually aware that the self-employment tax is coming at the end of the year, so it can be a real shock,” says Richard Chapo, a San Diego tax attorney.

Accurate accounting

Sole proprietors typically use single-entry accounting, logging all of their spending or payments in a personal checkbook. Corporations, however, use double-entry accounting, which requires two ledgers — one for debits and one for credits. That, says Fran Coet, a certified financial planner in Westminster, Colorado, creates a system of checks and balances that reduces mistakes.

The proof of that benefit is visible in statistics published in the the 2010 IRS Data Book. In 2010, the IRS audited only 0.4 percent of S corporations, but it audited 8.0 percent of individual business owners who made more than $100,000. That suggests that the safeguards afforded by double-entry accounting ultimately yield tax filings with significantly fewer errors or red flags signaling the need for review.

The IRS does not require partnerships, S corporations and C corporations with gross receipts of less than $259,000 and assets less than $1 million to show a balance sheet on their returns. However, even if corporations are not required to use double-entry accounting, Coet strongly advises they do so. Not using it poses risks: “There is no reconciliation of the disbursements and receipts," she said. "And that is a very dangerous approach if you want to comply with the requirement that a taxpayer file a complete, accurate and true tax return.”

Spreading the losses

Incorporating allows a company to carry losses forward, enabling it to lower the taxes for each year over which the losses are spread.

For example, if a company lost $60,000 in 2014 it could choose to carry that loss forward, typically for up to seven years in most states. If it then makes $100,000 in 2015, it can apply a portion of those losses to its income, lowering its taxable income accordingly, said Richard Chapo, a tax attorney in San Diego.

Disadvantages of incorporating

Moving from limited liability company to C corporation carries some disadvantages.

"For federal income tax purposes," the IRS explains on its website, "a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders."

Kell Riess, an adjunct business professor at Tulane University, noted that a corporation’s profits are taxed by state and federal governments for a combined rate of roughly 40 percent, and shareholder distributions are taxed at about 15 percent.

An LLC, by contrast, is a partnership, and only the partners pay taxes.

C corporations are also double-taxed when they attempt to distribute property out of the company, Riess said.

Assume, for example, that a C corporation owns a car for which it originally paid $25,000. Over a period of a few years the value of the car has depreciated by $22,000 to $3,000, but it carries a fair-market value of $7,000. If the C corporation distributes the car to a shareholder, the corporation will pay 39.5 percent to 40 percent in taxes on $4,000 — the difference between the assessed value and the fair market value. The shareholder must also pay taxes on the fair market value of the vehicle.

An LLC, however, is not required to pay taxes on property it distributes to its partners, so you may more easily distribute property, Riess said. C corporations also have additional filing requirements if they are public corporations, which can be extensive and time consuming.

C corporations also have to hold regular shareholder meetings and keep good records of the meetings.

Self-employment surprise

Being unincorporated leaves a business open to greater tax liability, especially when it comes to self-employment tax, according to Chapo.

“New businesses are not usually aware that the self-employment tax is coming at the end of the year, so it can be a real shock,” he said.

The sole proprietor of a business typically must pay self-employment taxes — Social Security and Medicare taxes — as well as federal and state income taxes on all earnings. If she incorporates her business, however, she may take a reasonable portion of the earnings as her taxable salary, so that the balance is not subject to self-employment taxes.

Lending disadvantage

Small business owners who are not incorporated face an uphill battle when it comes to taking loans out from banks, said Fran Coet, a certified financial planner in Westminster, Colorado.

“If you’re just a sole proprietor, Joe the plumber, and you have a truck and it’s just you, what do the banks have to look at?” Coet asked.

Businesses that have set up corporations, however, present a far superior financial picture to lending institutions.

“You’ve got accounting and financial statements instead of a bucket of receipts in the back of a pick-up truck," Coet said. "And a lot of people operate that way because a sole proprietor allows them to do that. There are no checks or balances.”

Business and personal taxes in one

Just answer simple questions about your business and life, and TurboTax Home & Business takes care of the rest.

For only $104.99*
Start for Free

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

* Important Offer Details and Disclosures
  • Try for Free/Pay When You File: TurboTax online and mobile pricing is based on your tax situation and varies by product. Actual prices are determined at the time of print or efile and are subject to change without notice. Special discount offers may not be valid for mobile in-app purchases.
  • TurboTax CD/Download products: Price includes tax preparation and printing of federal tax returns and free federal efile of up to 5 federal tax returns. Additional fees apply for efiling state returns. E-file fees do not apply to New York state returns. Prices subject to change without notice.
  • TurboTax Mobile: Actual prices are determined at the time of print or efile and are subject to change without notice. Come back here before you file to confirm that the price has not changed, especially if it's been a while since you downloaded this app.
  • Anytime, anywhere: Internet access required; standard message and data rates apply to download and use mobile app features and content. TurboTax mobile app devices supported include Android 4.1 and above, iOS 8 on iPhone 4s and above, and iPad 2.
  • Fastest refund possible: Fastest tax refund with efile and direct deposit; tax refund timeframes will vary.
  • Pay for TurboTax out of your federal refund: A $34.99 Refund Processing Service fee applies to this payment method. Prices are subject to change without notice.
  • About our TurboTax Product Experts: Customer service and product support (phone or chat) vary by time of year. Phone support not included with Free Edition.
  • About our credentialed tax experts: Live tax advice service is available for your toughest tax questions; fees may apply. Service, experience levels, hours of operation and availability vary, and are subject to restriction and change without notice. Click here for full terms and conditions. Not available for TurboTax Business customers.
  • Get up to 10% on top of your federal refund: Amazon.com Gift Card offer is for federal refunds only. Limits apply ($2000 per e-card, maximum $10,000 per customer). Offer available only for TurboTax Online (except Federal Free Edition) or CD/download versions sold and shipped, or downloaded directly from Intuit or Amazon. Except as required by law, Amazon.com Gift Cards cannot be canceled, transferred for value or redeemed for cash.

    Amazon.com is not a sponsor of this promotion. Except as required by law, Amazon.com Gift Cards ('GCs') cannot be transferred for value or redeemed for cash. GCs may be used only for purchases of eligible goods at Amazon.com or certain of its affiliated websites. For complete terms and conditions, see www.amazon.com/gc-legal. GCs are issued by ACI Gift Cards, Inc., a Washington corporation. All Amazon ®, ™ & © are IP of Amazon.com or its affiliates. No expiration date or service fees.
  • #1 best-selling tax software: Based on aggregated sales data for all tax year 2013 TurboTax products.
  • 4.8 out of 5 stars: Average based on customer ratings on TurboTax.com for TurboTax Online and CD/download products tax year 2014, as of January 2015.
  • Most Popular: TurboTax Deluxe is our most popular product among TurboTax Online users with more complex tax situations.
  • TurboTax CD/Download priority phone support: Priority phone support for TurboTax CD/Download Premier and Home & Business is accessible exclusively via the TurboTax.com Help Center.
  • Benefit Assist: After you file, TurboTax automatically shows you a full list of government benefits you may qualify for, like Food Stamps or reduced phone & utilities. Plus, we help you apply, saving you time and making it easier than ever to get more money! Estimate based on calculation of Benefit Assist users from tax year 2013 and published reports of average benefit and savings amounts from federal and state programs. Actual amounts and qualifications based on your individual situation; some individuals will not qualify. Feature may not be available for all customers.
  • Simplified State Experience: New, simplified state tax preparation available for most filers.
  • Eligibility for $25 cash back for returning Deluxe customers: Customers who have completed their 2013 taxes in TurboTax Deluxe (CD or download), and have completed their 2014 taxes in either TurboTax Premier or TurboTax Home & Business (CD or download), and apply here before 11:59PM PDT April 20, 2015, are eligible for $25 back. 2014 TurboTax Advantage users are ineligible for this offer. Terms and conditions are subject to change without notice.
  • $0 Upgrade Offer: Valid for customers who filed their 2013 taxes with TurboTax Deluxe (CD or download), completed prior year data transfer this year, and encounter an upgrade to either 2014 TurboTax Premier or 2014 TurboTax Home & Business (CD or download). Valid February 6, 2015 through April 20, 2015. TurboTax Advantage users are ineligible for this offer. This offer may not be combined with our $25 cash back offer. Terms and conditions are subject to change without notice.