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What No One Ever Tells You About Starting Your Own Business

How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners

 

Inc. Yourself

How To Profit By Setting Up Your Own Corporation

By Judith H. McQuown

Inc. Yourself: How To Profit By Setting Up Your Own Corporation by Judith H. McQuown is a classic, having sold over 500,000 copies and having been in print for over twenty years.

Inc. Yourself: How To Profit By Setting Up Your Own Corporation is a good book for people starting their first corporation. But, I have a problem with the subtitle, "How To Profit By Setting Up Your Own Corporation," which I feel is slightly misleading.

McQuown writes that forming a corporation can save you tax dollars compared to operating your business as a sole proprietor. And, to a limited extent, she is correct. However, McQuown doesn't carry her tax analysis through to full conclusion, which often involves corporate liquidation and retirement of the business owner. When a full tax analysis is done, the results of the tax savings of incorporation, compared to operating as a sole proprietor, are substantially less.

Let's divert for a moment and consider the tax savings which accrue to individual investors in a 401(k) retirement plan. Suppose you are in the incremental 31% income tax bracket and you invest $1,000 in your company's 401(k) (you're an employee of a larger corporation now, no longer the free-wheeling entrepreneur!).

Because the money contributed to the 401(k) reduces your taxable income by the full amount of the contribution, you save $310 in taxes. That is the tax savings achieved by making the contribution to the 401(k). Or, is it?

Under most cases, this simple analysis misses the fact that the money contributed to the 401(k) is only tax-deferred, i.e., it is not "tax free." You still have a tax liability, which will be invoked when the money is withdrawn from the 401(k). When money is removed from a 401(k) during retirement, it is taxed as ordinary income.

Let's assume it is only one year after contributing the money to the 401(k), and let's further assume that you've had a rather poor year with your investments. You just broke even. Your $1,000 didn't grow at all, but fortunately, it didn't shrink any either! Given the current market, we'll be happy with that!

Let's also assume that this is your year for retirement. Congratulations! Your retirement was the result of winning the lottery! Consequently, you have excellent income from non-401(k) sources. This other income puts you in the 31% incremental, income tax bracket.

Winning the lottery is especially fortunate, as you only have $1,000 saved for retirement! If you withdraw the $1,000 in your 401(k) during this first year of retirement, you will owe $310 in taxes. (Of course, you would probably just let the money remain in the 401(k) hoping for future growth, or transfer it to an IRA and leave it in there as long as possible). In this case, we see that the actual tax savings are zero. You have not saved any money by investing via the 401(k).

This isn't to say that investing in a 401(k) is bad. On the contrary, it's an exceptionally good idea. But, it does show that money placed in a 401(k) will usually invoke taxation upon withdrawal. It is incorrect to say that you saved $310 in taxes, because you gave no consequence to the future tax liability.

[Incidentally, you could work this example, assuming a very successful investment year, where your holdings doubled in value. The $1,000 grew into $2,000 before being withdrawn from the 401(k). Given this 100% rate of return, when the money is withdrawn from the 401(k), you pay $620 in taxes total. After all taxes, you have $1,380.

Had you invested the $1,000 outside of the 401(k), you would have paid $310 in taxes on the initial $1,000 leaving only $690 for investment. Getting the same 100% rate of return outside the 401(k) would have doubled your money to $1,380. However, you still owe taxes on the net gain of $690. At the 31% tax rate, this amounts to $214 in taxes, leaving a total of $1,166 remaining after all taxes. So, in this case, you came out ahead by $214 by investing within the 401(k).

We see that the big advantage of making the investments within the 401(k) is that money ($310 in the example) which would have been paid in taxes remains within our 401(k) investment portfolio to compound and grow. That is the advantage of the tax-deferred investment. Because time is such a crucial factor to compounding, getting started early investing via a 401(k) is especially valuable, as it maximizes the gains all those tax-deferred dollars will achieve.

Another advantage of investing within the 401(k) is that your tax bracket will likely be lower during retirement than during your earning years. Maybe, for example, you'll only be in the 28% tax bracket and not the 31% tax bracket.]

With that taxation preamble, we return to Inc. Yourself: How To Profit By Setting Up Your Own Corporation, and note that McQuown states that an especially powerful advantage of forming a C-corporation is the powerful "income splitting" capability of having a C-corporation. This means that because your corporation is a separate, taxable entity from yourself, you can effectively have the corporation pay part of the total tax bill generated by your business activities, while you as an individual pay the other portion of the total tax bill.

This is done by paying yourself a wage, which is tax-deductible by your corporation (hence, the corporation pays no income tax on wages paid to you), while part of the corporate earnings remain within the corporation and are taxable to the corporation as corporate profits (hence, you pay no personal taxes on this retained money).

Of course, income-splitting is most appealing when the income split reduces your incremental tax rate to a lower tax bracket. For example, assume you have $5,000 which falls into the 28% individual-income tax bracket when you operate as a sole proprietor. Had you formed a C-corporation, this $5,000 could have stayed in the corporation and could have been taxed at only 15%. This amounts to a $650 tax savings. Or does it?

That is a complex question. If the $650 can be used effectively within your company, the income split may prove very useful. However, money retained by a C-corporation isn't your money. It is the corporation's money, as McQuown acknowledges.

If you wish to use this retained money for personal purposes which aren't justifiable business expenses, withdrawing the money from the corporation will involve paying extra taxes on the money. McQuown never takes these future tax liabilities of income retained by a C-corporation into consideration in calculating the money "saved" by income splitting.

In fairness to McQuown, she does have an excellent section, Advantages of S Corporation Status, where she writes: "Because corporate profits are taxed every year whether they are distributed or not, there is no buildup of corporate assets, as there frequently is in a C corporation. This simplifies matters when you are ready to liquidate your corporation at some future date. It also removes a great deal of uncertainty because no one knows how favorably corporate liquidations will be taxed several years down the road. At present, corporate liquidations do not have attractive tax-exempt provisions."

The money retained in the C-corporation (via "income splitting") only has five possible fates.

One, it is returned to you during a future taxable liquidation.

Two, it is returned to you via a dividend, declared by your company, which is especially undesirable, as this dividend would, then, have been taxed twice.

Three, the money is returned to you as wages paid for services rendered. This is undesirable to some because it involves paying Social Security taxes in addition to personal income taxes on the money.

Four, the money is retained within the C-corporation and spent on "things" which benefit you, but are allowed as tax-deductible and justifiable business expenses to the C-corporation, such as medical expenses, which McQuown discusses in a short chapter.

Five, the money is retained by the company and is used to build and grow the business. (We neglect the sixth option... losing the money via bad business decisions. We also neglect the seventh option... dying, which McQuown notes changes the basis in the stock for our heirs to the stock's current value, eliminating the taxable, capital gain we as the original stock owner would have owed. And, we neglect the eighth option... selling your corporation. The reason we neglect selling the corporation is that we assume you have a personal business which has little value in the business market.).

To show the need to consider future tax liability to ascertain any true "tax savings" of incorporation, let's consider the dividends-received-deduction. McQuown mentions the dividends-received-deduction as being a significant advantage of forming a C-corporation. She mentions it repeatedly, in fact!

The dividends-received-deduction says that a C-corporation only needs to pay income tax on 30% of the dividends received from investment in another domestic corporation, e.g., 70% of any dividends received from investments in other corporations are tax-deductible. Because, the marginal income tax bracket for many smaller corporations is 15%, this amounts to an effective income tax rate on dividends of only 4.5% (calculated as 0.3 * 0.15).

While paying 4.5% in corporate income tax is much less than paying 28% personal income tax, for example, on dividends received from investments in other corporations, is the dividend-received-deduction the "enormous" benefit McQuown claims it is?

McQuown writes: "... a sixty-year old professional could incorporate and turn over his stock portfolio to his corporation, at which point his dividends would be 70 percent tax-exempt. As long as his earned income constituted 40% or more of his total annual income, he would not be held to be a personal holding corporation. He could then retire at sixty-five or seventy with lots of tax-free dividend accumulation and a fairly high basis on his stock, so that when his corporation was liquidated, a good part of the assets would be considered a return of capital and therefore be tax-free."

While the above sounds good, the reality is that when it is all calculated out, the tax advantage vanishes. Consider investing in a stock which maintains the relatively high (today) dividend yield of 5%.

For simplicity, assume the dividends are paid at the end of the year. Assume the dividend yield remains fixed at 5% (i.e., the dividend yield on the stocks isn't growing, but the dividends received are growing). Assume that the net income received from the dividends grows at an 8% pretax rate of return, via reinvestment in the stock. In other words, in addition to a 5% dividend yield, we also receive a 3% growth in share value each year (capital gain). Due to this, even as the dividend yield is held fixed, the amount received in dividends is growing. We'll assume these dividends are reinvested in more of the same stock. These assumptions give the maximum advantage to any tax savings acquired by the dividend-received-deduction.

If the money received from dividends were reinvested in bonds, for example, there would be a lower total tax savings than our example shows. Also, we will assume the effective tax rate on dividends of 4.5% as calculated previously. If our incremental, corporate tax rate were 34%, then, the effective tax rate on dividends received would be 10.2%, making the dividend declared deduction less valuable.

To make the situation more concrete, let's assume that the share price of the stock begins at $10 per share, and we buy 4,000 shares for a total investment of $40,000. This assumption doesn't affect our tax-savings conclusion in anyway, but it makes it easier to visualize what's happening.

First, for dividends paid to the corporation:

# Shares Price Per Share Dividends Total Tax To Reinvest Ending Share Value # Shares Acquired Total # Shares Total Value
4000 $10 $2,000 90 1910 10.30 185.44 4185.44 $43110
4185.44 10.30 2155.50 97 2058.5 10.61 194.04 4379.47 46461.80
4379.47 10.69 2323.09 104.54 2218.55 10.93 203.03 4582.50 50074.21
4582.50 10.93 2503.71 112.67 2391.04 11.26 212.44 4794.94 53967.48
4794.94 11.26 2698.37 121.43 2576.95 11.59 222.29 5017.23 58163.45
(Note: I rounded values in table to two decimal places)

The First Column (# Shares) is the number of shares we have at the beginning of the year. The Second Column (Price/Share) corresponds to the Price/Share at the start of the year. The Third Column (Dividends) refers to the dividends received during the year. The Fourth Column (Total Tax) refers to the total tax we owe on the dividends (calculated at the 4.5% effective tax rate).

The Fifth Column (To Reinvest) is the dividend dollar amount that remains to be reinvested (calculated as Dividends minus Total Tax paid on the dividends). The Sixth Column (Ending Share Value) is the per share value of the stock at the end of the year. Recall, we assume the stock is appreciating in value at 3% a year in addition to paying dividends.

The Seventh Column (# Shares Acquired) is the number of new shares we are able to buy at the end of the year. Recall, we are reinvesting the dividends to buy more of the same stock. (Calculated by dividing the "To Reinvest" Column by the "Ending Share Value"). The Eighth Column (Total # Shares) is just the number of shares we have at the end of the year. And, finally, the Ninth Column (Total Value) is just the ending value of our total stock holdings at the end of the year.

We see that, at the end of five years, the corporation's total investment has grown in value to about $58,163, given the assumptions of reinvestment of dividends, a fixed 5% dividend yield, and 3% annual appreciation in stock value. Incidentally, we are allowing for fractional shares to make life easier.

Also, notice, that we could calculate the after-tax return of the investment each year by dividing the "Total Value" at the end of the year by the "Total Value" for the year before. $40,000 grows into $43,110 during the first year. $43,110 grows into $46,461 the second year, etc.

So, the first year after-tax rate of return is just $43,110/$40,000 = 1.07775 which corresponds to a 7.775% annual after-tax rate of return. Similarly, the after-tax rate of return for all other years is 7.775%.

This makes sense, because the stock is appreciating at 3% per year, and the stock is paying dividends of 5% per year which are taxed at the effective rate of 4.5%, so the total return from this investment is = 3% + (1- 0.045)(5%) = 7.775%.


So, we could have simply calculated the ending value of our $40,000 initial investment as: $40,000(1.07775)5 = $58,163. This is the ending value of the investment that resides within the corporation.

Similarly, we could easily create a second table showing "Second, for dividends paid directly to the individual:" That table would show how the portfolio grows outside the corporation. Let's assume a personal income, incremental tax rate of 28%. Rather than create the whole table, we'll just calculate:

3% + (1 - 0.28)(5%) = 6.6% growth rate.

$40,000 (1.066)5 = $55,061.

Which shows that outside the corporation, our investment is only growing at 6.6% and it grows into $55,061 rather than $58,163. So, it appears our tax savings is $3,102 by holding the stocks within the corporation.

However, we still must consider how the money will exit the corporation and enter our personal holdings. Here is where McQuown glosses over the issue. Inc. Yourself: How To Profit By Setting Up Your Own Corporation has a six-page chapter, "Retire with the Biggest Tax Break Possible," where McQuown discusses corporate liquidation.

McQuown points out that, upon corporate liquidation, the stockholder will pay capital gains tax on the appreciation in value in excess of his/her basis in the stock. Then, she casually writes, "Whether the corporation pays taxes depends on its basis...." She notes that, currently, any capital gain is taxed as ordinary income to the corporation.

Let's calculate our tax savings. By adding our initial investment of $40,000 to the total of all dividends received and previously taxed and reinvested in new shares (add up all values in Column Five, "To Reinvest" in the table above), we see the corporation has a total stock basis of about $51,155. (Note, I'm not an accountant and not rendering advice on how to calculate your basis in assets and investments. When in doubt, consult the appropriate IRS booklet. As McQuown acknowledges, "Liquidating your corporation can be tricky, with many potential pitfalls. And, tax treatment of C and S corporations differs tremendously. Make sure to get good accounting advice the year before you plan to close shop.")

The taxable amount to the corporation is: $58,163 - $51,155 = $7,008. Now, this $7,008 is taxed to the corporation as ordinary income, as McQuown points out. What is the appropriate incremental tax rate to use? Upon liquidation, our corporate tax rate might be as high as 34%. Let's assume it is only 15%, the absolute minimum it probably would be.

We pay about $1051 in corporate income taxes. This reduces our corporate investment from $58,163 to a total worth of $57,112. This still represents a tax savings of $2,051 over the $55,061 we would have by holding the stock outside the corporation. But, we aren't done yet!

We must allow for the fact that, upon corporate liquidation, the net investment gain will now be taxable to us at the personal capital gains tax rate. Our personal basis in our corporate stock is $40,000 (the value of the investment stock initially contributed to the corporation. Note: Basis works very differently for S-corporations. As a C-corporation holder, our basis in the contributed stock hasn't increased, as corporate taxes are paid on dividends received. It's also important to distinguish between the basis in our own company's stock and the basis in the stock the corporation purchased as an investment.). The liquidating value of the C-corporation, in our example, is the value of its one only holding, the dividend paying stock, valued at $57,112 after corporate tax expense on the liquidation.

Thus, we must pay capital gains tax on $17,112. At a 20% capital gains tax rate, this amounts to $3,422. This reduces our overall, personal amount received after the liquidation to only $53,690 which is less than the $55,061 we could have achieved by just holding the stock outside of a corporation!

Now, it is true that we could calculate our personal basis in the stock held in our personal portfolio and assume the sale of the stock upon retirement. This would invoke a slight capital gains tax on the gain. However, there might well be no need to sell the stock held in our personal portfolio. Assuming it is a solid company, we could hold it another twenty years during retirement.

So, where are our big tax savings by contributing high-dividend paying stock to our own corporation and invoking the dividend-received-deduction?

It seems a person five years away from retirement, who forms a corporation for the purpose of contributing high-dividend paying stock to it, so that the dividends are somewhat tax-sheltered, is probably making a serious error.

A big part of the reason the dividend-received-deduction isn't as valuable as it might appear is because, along with dividends received, most stocks will appreciate in value. Outside a C-corporation structure, this appreciation isn't taxed until sale of the stock and is taxed at the favorable, personal, capital gains tax rates (capital gains tax rates are constantly changing and appear to be getting more favorable, but who knows what the tax laws will say down the road?). However, within the C-corporation, this appreciation is taxed upon liquidation of the corporation. And, it's taxed twice.

McQuown also fails to address the issue of what happens to liability in the event of a corporate liquidation. The best reason to incorporate has always been to limit legal liability, as I discuss in Thinking Like An Entrepreneur.

Inc. Yourself: How To Profit By Setting Up Your Own Corporation has a very good chapter, "Getting Ready," which walks the potential entrepreneur through the process of forming a corporation. Appendix A has a listing of the State Offices to contact to get your corporation rolling. Appendix B has sample minutes and bylaws for a small corporation. Throughout the book, sample government forms and federal tax returns are shown.

McQuown devotes a special chapter to women and minorities, where she discusses taking advantage of minority-supplier contracts. She writes, "Federal contracts can be an undiscovered gold mine. They are not well advertised. If you think your corporation can provide useful services, make a beeline for your local Small Business Administration office and get some advice. Remember: You're paying their salaries. SBA offices are located in state capitals..."

McQuown continues: "Yes, of course they're quotas! But after all these years when women- and-minority-owned businesses have gotten what Marilyn Monroe called 'the fuzzy end of the lollipop,' it's time to tilt the balance just a bit in their favor through affirmative-action projects."

Inc. Yourself: How To Profit By Setting Up Your Own Corporation goes on to discuss Small Disadvantaged Business (SDB) status, "SDBs qualify for [governmental] contracts without undergoing competitive bidding and can win them even if they are 10 percent higher than the low bid. In 1996 SDBs received $6.4 billion in federal contracts."

Overall, Inc. Yourself: How To Profit By Setting Up Your Own Corporation by Judith H. McQuown is a very good book, as it discusses many issues of corporations which people might not know. Topics, such as the deductibility of medical insurance, are important to many small business owners and the self-employed (these tax laws also are constantly changing). The book is also highly readable. However, I do disagree with some of the statements and conclusions drawn by McQuown. And, the subtitle is a bit much.

How about a new subtitle: Inc. Yourself: How to Profit, Lose Twenty Pounds in Six Weeks, and Become More Attractive to the Opposite Sex by Setting Up Your Own Corporation? I don't know about the "Profit," but you might well lose some weight carrying around your corporate records. And, you will certainly become more attractive to the opposite sex, when you introduce yourself as So-and-So, President, Founder, and CEO of MyWidgets, Incorporated.

Inc. Yourself: How To Profit By Setting Up Your Own Corporation
Inc. Yourself:
How To Profit By Setting Up Your Own Corporation

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