Summary:
Incorporating could increase taxes. Study problems before deciding on LLC or corporation. IRS auditors try to treat benefits to shareholders as a dividend.

Owners of a new closely held business often must choose a type of entity to operate under.

This column discusses seven tax reasons not to incorporate a closely held business. Most problems arise from attempting to avoid a second tax: Shareholders pay taxes when they receive profits as dividends even though the corporation already has paid on those profits. These dividends can be unexpected. If a transaction benefits a shareholder at the expense of the corporation, it's a dividend, even if the corporation hasn't complied with dividend formalities. It's called a constructive dividend: taxable to the shareholder but not deductible by the corporation.

The corporation can prevent or mitigate the problem by consistently paying a substantial part of profits as a dividend. But who wants to voluntarily pay the double tax?

IRS agents love to audit closely held regular C corporations. They easily find constructive dividends and other tax opportunities. Here are seven:

Bargain sale: If a corporation sells an asset to the shareholder at less than market value, the difference between the sales price and market value is a dividend.

Paying personal expenses: If a corporation pays expenses of a shareholder or purchases an asset for the shareholder, it's a dividend. Done often enough, this could result in a fraud penalty or jail time.

Loans to shareholders: If a corporation loans money to a shareholder, it can result in a constructive dividend. The key here is whether the corporation treated the loan as a bank would. So you should represent the loan with an interest-bearing note and a payment schedule the shareholder complies with. The shareholder should give the corporation security if a bank would require it.

Unreasonable compensation: If a corporation pays a shareholder/employee excessive compensation, the overpayment is a dividend. Therefore, it doesn't get a deduction. The problem especially exists where only shareholders receive bonuses, it has paid little or no dividends compared to profit, the payment's allocation coincided with stock ownership or the corporation paid compensation as a year-end bonus when it knew the profit amount rather than monthly salary checks. The question courts often ask: Would an independent, non-employee shareholder approve such compensation considering the nature and quality of the shareholder-employee's services?

Accumulated earnings tax: If a corporation doesn't pay sufficient dividends relative to profits, it has the potential of being subject to the accumulated earnings tax. This is a tax on top of the regular corporate tax. If the corporation accumulated earnings instead of paying dividends, it could be taxed on its excess assets. This includes cash not needed for operations, receivables from officers and investments unrelated to the business.

Liquidation: If a corporation liquidates and distributes assets to shareholders, it's taxed as if it sold its assets for market value. And the shareholders are taxed on the market value of what they receive in excess of their stock basis.

Moving from a regular corporation: If a corporation moves to LLC status, this will be taxed as if the corporation liquidated.

Still, if an LLC isn't acceptable, the regular C corporation might elect, if eligible, to S corporation. An S, however, has its own pitfalls. Also, hidden taxes can result from converting from regular to S.

A new business owner must weigh advantages and disadvantages of a C corporation, an S corporation and an LLC. Do it carefully and with advice from a business tax CPA or tax lawyer.

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