To Incorporate or Not to Incorporate

by PATRICIA RICE

As some of you fortunate people struggle with the shock of increasingly higher tax burdens, you may have wondered if there are any tax advantages to incorporating. Like any accounting question, the answer is: that depends.

Incorporating your writing income when you reach certain income levels can be a tax advantage in the right hands, under the right circumstances. It is very definitely not for everyone.

If you are irritated with keeping books, filing receipts, talking to accountants, or all of the above, consider your decision closely before thinking in terms of incorporation. Corporations are businesses. The Internal Revenue Service may give a little leeway to individuals running a small business on a Schedule C. They realize that not all of us are precise bookkeepers. But an individual who goes to the legal trouble of becoming a corporation is saying s/he is experienced enough to operate a real business. There are no excuses such as "the dog ate my receipts."

Incorporating requires going to a lawyer who will assist you in writing bylaws and articles of incorporation and filing them with the proper state authorities. S/he can also check to see if another corporation name exists under the one you have chosen. They will see that you receive a minute book and a corporate seal. These are not for collecting dust. They have legal purposes and must be used accordingly. I can't speak of the cost of all this because it varies from city to state, but in my rural area, the charge for these legal services probably falls in the neighborhood of $250. This will be the first of many costs, so be prepared.

If you're sitting there, wriggling, saying "Yes, but what is this going to save me?", bear with me. I'm trying to make a point here. Incorporating isn't just about saving taxes. It is a state of mind. When you get finished with your writing each day, you must put on your corporate top hat and think like a CEO. Experience tells me that isn't particularly practical for many of us.

That's where your friendly accountant comes in. If s/he's dealt with you before and knows you've never kept an accounting record in your life, s/he's going to scream in agony when you suggest incorporating--either that, or start licking his lips and considering that new Lincoln Towncar he's been looking at.

Corporations must have accounting books. Not only must they have books, they must have payrolls, and payroll records requiring monthly or quarterly reports. If you cannot complete these forms or keep the proper records, your accountant will have to do it for you. That costs money. S/he will also be filing corporate tax returns as well as your individual returns. That's more money.

Corporations must be treated as uninterested third parties. If you incorporate, you cannot decide to buy your son a new car and write the check out of the corporation. You cannot go to Wal-Mart and buy all the latest romances along with your detergent, pay for it out of your personal account, and then ask the corporation to reimburse you. Would your employer reimburse you for a receipt like that? I don't know any that would.

I trust by now you're beginning to get the picture. Incorporation is a serious business. If you are not capable of keeping books and payroll records, you are going to have to pay an accountant to do what you cannot. Reasonably intelligent, organized persons can keep the accounting costs down with a little tutoring from their friendly accountants. If you're fortunate, you may have a spouse or child who loves bookkeeping. Take stock of your abilities and those of your family before stepping off the deep end.

If you've gone this far and have decided you can handle the business end of incorporating, we'll complicate matters a little further. There are two basic types of incorporation (actually, there are several, but they're complicated and not particularly applicable to most writers). The very most basic corporation is called an S corporation, for small business corporation. With an S corporation it might be possible to circumvent payroll for a while, but not forever. The IRS really likes to fill the Social Security pot so the government can borrow from it. An S corporation deprives them of that money unless you have payroll or pay out money to yourself as contract services, which of course kicks in the hated self-employment tax.

An S corporation will not really save you anything except self-employment (Social Security) tax. The entire profit left in the corporation at the end of the year is reflected directly on your individual income return, on Schedule E instead of Schedule C. This avoids the self-employment tax, but not income tax. Of course, most of us tend to live off our writing income, so it doesn't stay in the corporation for long. It gets paid out to ourselves in whatever clever ways our CPAs devise, and that's where we begin playing games.

If you can pay some of the money out of the corporation to yourself as rent or interest, you can avoid paying self-employment tax even on amounts you take out of the corporation for yourself, but you must have a legally valid reason for those payments. You can't just decide to pay yourself $300 a month for the use of the desk in your bedroom. The IRS would swallow you whole and burp you out.

An S corporation can pay out distribution (money) to owners (you) without the owners paying self-employment taxes, but that dodge is limited. If you are paying yourself $1000 a month in distributions and not paying any wages or contract services to yourself, the IRS will come in and decide that $1000 was merely avoidance of taxes, reclassify it as wages, and charge you payroll taxes and penalties until you wish you'd never heard of incorporating. An accountant can advise you on the best way to handle payments to yourself.

If your only income is from writing, then an S corporation may make sense until you reach a certain level of income. The social security cutoff for 2001 is $80,400. If you continued filing simple individual tax returns (Schedule C) until you earned that amount, you would be paying 15.3% in self- employment taxes plus 23% in federal income taxes, a total of 38.3% of your income just in federal taxes or roughly $30,793.

If you put all your writing income into an S corporation, you could conceivably avoid all self-employment taxes and only pay the 23% in federal income taxes, depending on your comfort levels with the IRS requirement that you pay yourself wages. Even if you're making $80,400 and pay yourself $20,000 in wages, the tax bill would be approximately $22,227, a savings of $8566 over Schedule C. Those of you fortunate enough to make over $80,400 in net income lose most S-corporation tax benefits for amounts over that self-employment cut-off. People in that bracket have different sets of problems. If you're at all familiar with the tax laws, you realize that individuals pay higher percentages of taxes as income levels increase. A single person pays a 15% tax up to an income of $27,050 in 2001, 27.5% tax from $27,050 up to $65,550, and then things get really complicated. Obviously, to keep taxes down, a person must keep taxable income in the lower tax brackets. With an S corporation, that's not possible. Everything you make (less expenses) ends up on your individual income tax return. If you and your spouse are fortunate enough to make more than $100,000 in taxable income you are paying over 28% of your income for federal income taxes alone. Add to that your state income tax plus the 15.3% on anything called self employment income, and you can easily pay more than 50% of your income in taxes. (That's where your money went last year. You never realized you hadn't just frivolously spent it, did you?)

When you start reaching those kinds of brackets, the C corporation begins to look attractive. All your income stays within the C corporation and is taxed at corporation rates until you pay it out in some form or another. I'm not saying corporation rates are lower, because they're not (until the Republicans get hold of them, anyway). What I'm saying is that the corporation gives you a way of splitting your income to keep the rates in the lower brackets (unless you're Stephen King, in which case you don't need free advice like this but can afford a fleet of accountants to worry over your soaring taxes).

If your writing earned $100,000 in 2001, you would be taxed at the 28% plus 15.3% rates (up to $80,400) on your individual return as a sole proprietor, even if you stick the money in the bank and don't spend it all. If you incorporated and only paid yourself $50,000 in wages and rents knowing you'd need the money next year, the corporation would pay 7.65% in deductible FICA taxes, a small figure for deductible unemployment taxes, and a corporate income tax of 15% on the net income figure after your wages and taxes were deducted. Individually, you would pay 7.65% in social security withholdings and 15% in federal income taxes. The sole proprietor would have paid a total of $38,022 for the year, while the incorporated writer would have paid only $22,488. Aside from saving on self-employment, splitting income between corporation and the individual puts the payer in a different tax bracket, thus saving federal taxes as well.

Example: a single writer with $100,000 net taxable writing income in 2001 after commissions and the usual business expenses:

These are wildly simplified examples, as anyone with a minimum of accounting experience can tell you, but it gives a rough estimate of the differences in tax structures. By incorporating, you are giving yourself a means of controlling how your income will be taxed. The above example assumes maximum avoidance of self-employment tax, but an S corporation becomes less effective once your wages go over the Social Security limit of $80,400 in 2001, simply because an S corporation controls only self-employment taxes.

A C corporation is only truly effective in saving income taxes if you accumulate a bank account at the end of the year. If the writer in the above example had paid out the entire $100,000 in wages, the tax benefit would have been minimal. As you can see, an accountant will best be able to tell you what would work for you.

There are other advantages to incorporating that I don't have room to go into here. It's possible, if you aren't covered under other medical insurance, to use your C corporation as a means of paying medical benefits and making them tax deductible. For those of you paying your own medical insurance, this could be a giant savings even without the other tax benefits. There are other tax loopholes and legal liability situations that apply to corporations and not to individuals, but if you're truly serious about considering the road to incorporation, it's best to sit down with your accountant and attorney and map out the advantages and disadvantages that apply to you specifically.

For those of you who actually made it through this article and understood enough of it to still want to consider incorporating, you've got what it takes to be a CEO. Go for it.

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