Living the Lobster Life

When you opened your first lemonade stand as a kid, you made your first business tax decision.  While you didn't realize it, you were choosing to operate as a sole proprietor (you did report that income, right?). 

Grownups often put no more thought into how they run their businesses.  The historic default choice for adults was to operate as a corporation.  The lure of 15% corporate tax rates on the first $50,000 of taxable income still entices many folks into the C corporation.  What could be simpler? 

Many things, as it turns out.  A wise tax lawyer writes:

Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of. 

Life in a corporation can involve lots of complications over the years.  This is especially true for life as a "C corporation," which pays its own taxes; this contrasts with an "S corporation," where the shareholders pay the tax on the corporation income.

• When you're ready to take income out of a C corporation, you have to pay another tax.  If you cash out with a dividend, it's taxable; if you sell your stock to someone, that's taxable too.  You pay two taxes on C corporation income, in other words; the corporations pays taxes when the income is earned, and the owner pays taxes when he takes out the cash.

• If you take the earnings out as salary, you don't pay a second income tax, but the salary is subject to FICA and Medicare tax.

• If you lose money when you start a C corporation, the losses are stuck there until the corporation makes some money; they aren't available to reduce your personal taxes.

• If you make a lot of money, you find that the benefit of the 15% rate starts to be recaptured, and is gone completely once corporate income hits $335,000.

• If you are a lawyer, accountant, doctor or consultant, you might find that you don't even get the 15% rate at all.  You face a 35% rate from dollar one.

• When you've had your fun and it's time to move somewhere warm, it can be hard to sell corporate stock.  People prefer to buy assets.  If you buy stock, you buy all of the company's history, including any bad deeds.  Selling assets can be expensive.  There is no capital gain break for C corporations that sell assets, so you can have a lot of income taxed at a 35% federal rate - and don't forget Iowa's highest-in-the-nation 12% corporation tax rate.

That's not to say that C corporations are always bad.  Many effective tax structures involve a C corporation.  But don't incorporate until you've had a chat with your tax pro.  That lobster pot can get a bit cramped.

Photo on Flickr by rubber cat