Tax Trap #2 -- Double Taxation: Isnt Once Enough?
Have you been thinking about incorporating your smallbusiness or self-employment activity? The advantagesare many!
For starters, you'll be protecting yourself and your familyfrom the possible of a business ending lawsuit. Forming acorporation is Step One on the path known as "AssetProtection" -- you are moving from the world of unlimitedliability to the world of limited liability.
(NOTE: For further insight into the legal advantages ofincorporating, check out the article: "It Can Happen To You:Why Any Sole Proprietorship Is A Risky Business" athttp://www. YouSaveOnTaxes. com/happen-to-you. html)
From a tax standpoint, there are both advantages anddisadvantages to incorporating. Yes, forming a corporationcan either reduce your taxes or increase your taxes, depending on what type of corporation you create.
There are two main types of corporations: "C" Corporationsand "S" Corporations -- and which type you choose can makeall the difference in the world of taxes.
NOTE: The question of "C" Corp vs. "S" Corp has no effecton the asset protection provided by your corporation. This is a tax issue, not a legal issue.
A "C" Corporation can lead you into a Tax Trap known as "double taxation". Yes, income from a "C" Corporation canactually be taxed twice -- once when it's earned on thecorporate level and again when it's paid to you, the shareholder, in dividends.
There are several ways to avoid double taxation. Oftenthe easiest way is to tell the IRS that you choose tobe an "S" Corp instead of a "C" Corp. The profits ofan "S" Corp are not taxable to the corporation; instead, those profits are reported directly on the shareholder'spersonal income tax return and are therefore onlytaxed once.
And once is enough, don't you think!
Of course, any article on Choice of Entity must containthe old disclaimer, "Consult your tax professional" -- I am not prescribing a one-size-fits-all approach tothis issue. But for many small biz owners and self-employedfolks, the "S" Corporation is a good fit becauseit provides protection from personal liability andavoids the nasty tax trap of double taxation -- twogreat benefits worth checking into.
Should you incoporate your sole proprietorship and thendecide that the "S" Corporation is the right fit, you must inform the IRS that your corporation is choosing"S" Corporation status by filing Form 2553, which is, in effect, an application to become an "S" Corporation.
IMPORTANT:If you incorporate and do not file Form 2553, you areautomatically considered to be a "C" Corporation by the IRS. In other words, to be a "C" Corporation, you just incorporate; there is nothing you have to do to inform theIRS you want to be a "C" Corporation.
There are critical rules regarding how and when to fileForm 2553, so be sure to read the instructions carefully, or check with your tax pro.
Failure to file Form 2553 on time or filing Form 2553incorrectly results in a rejection of your corporation's"S" Corp application, and the corporation is then by defaulttreated as a "C" Corp, subject to double taxation, thevery trap you were trying to avoid.
To download a copy of Form 2553, go to:http://www. irs. gov/pub/irs-pdf/f2553.pdf
The instructions for filing Form 2553 are found here:http://www. irs. gov/pub/irs-pdf/i2553.pdf