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Debunking the Incorporation Tax Myths

Most weeks my CPA firm offices take a telephone call from a new small business owner looking for a tax accountant. Usually, after some chit-chat, the caller gets up the courage to ask awkwardly about those barely legal ways the savvy businessperson can reduce taxes by incorporating.

I always try to be friendly as this conversation unfolds. Hey, I know the score. This entrepreneurial newbie has at some point in the past heard and then believed one or more of the urban tax myths about how corporations save small businesses tax.

Now make no mistake: Incorporation can be an excellent business decision. Incorporating a business always reduces the business owner's legal liability at least a little bit. And incorporating a business can sometimes reduce some of the taxes a business pays (such as payroll taxes). But incorporation doesn't magically save a business owner from paying taxes. In particular, entrepreneurs and business people should not fall for three urban myths about taxes...

Incorporation Tax Myth #1: Extra Tax Deductions

The most common tax myth may just be that by incorporating, a business owner receives extra tax deductions. Like many myths, there's a grain of truth here. But business owners should know that, for the most part, tax laws allow a business to deduct any ordinary or necessary expense.

The definition of what's "ordinary and necessary" doesn't change because one business operates as a corporation or another business operates as a sole proprietorship.

For example, a small business operating as a sole proprietorship doesn't get to deduct extra amounts or personal expenditures merely because the proprietor incorporates.

And that means you shouldn't incorporate a new or ongoing venture on the basis of the "extra deductions" myth.

Incorporation Tax Myth #2: Avoiding State Income Taxes

Many entrepreneurs in high tax states want to believe another common myth... the myth that incorporating in another low-tax or no-tax state will save taxes. For example, many California businesses want or would like to believe that incorporating their business in Nevada means the business doesn't have to pay California state income taxes.

One understands the source of this myth. A Nevada corporation operating in Nevada doesn't have to pay state income taxes. Yet a California corporation operating in California does have to pay state income taxes. Why can't a California entrepreneur incorporate his business in Nevada? Won't that allow the business to avoid California state income taxes?

Unfortunately, no.

Here's why: The state of incorporation doesn't determine which state's tax laws apply. What matters is the state or states in which a business operates. For example, if a Nevada corporation operates 100% in California, California gets to tax 100% of the income earned by the Nevada corporation. Similarly, if a California corporation operates entirely in Nevada, California doesn't get to tax the income earned by the corporation. Nevada does--or at least Nevada could tax the income if it chooses to.

The bottom-line? You should not incorporate in another state as a way to save state income taxes. The technique doesn't work.

Note: Another related technique does work and deserves mention: You can move your business to a low-tax state, begin operating from that state, and then save state income taxes that way.

Incorporation Tax Myth #3: Sheltering Income from Taxes

One final and somewhat odd myth about incorporation deserves busting...

Some new business owners understand that if a corporation earns profit but doesn't pay out that profit to the shareholders, the shareholders don't have to pay income taxes. This bit of trivia sometimes triggers the idea that maybe a shareholder can shelter income by "leaving" cash inside the corporation.

What this myth gets wrong is that while a business owner can avoid personal income taxes by leaving profits inside the corporation, the corporation then gets taxed on those profits. In this case, the business owner hasn't really reduced the taxes levied on his or her entrepreneurial activities. Rather, he or she has in effect written the check from a different bank account.

And another facet of using a corporation to shelter income from taxes should be mentioned. When the shareholder moves the money out of the corporation, he or she will pay taxes on the dividends. When one combines the corporate income taxes paid by leaving money in the corporation and the later dividends tax paid by the individual, the pursuing incorporation myth #3 may actually cost the entrepreneur more in taxes.

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