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Have you seen the ads in the in-flight magazines proudly proclaiming "I Incorporated!"? Or have you heard the radio commercials of the National Audit Defense Network touting all of the tax deductions you have missed? Are you missing a great opportunity? Not likely.

Forming a corporation does not change personal expenses into business expenses. If you currently operate a business as a sole proprietorship, you report your business income and expenses on Schedule C of your personal income tax return (Form 1040). Legitimate business expenses are deductible on Schedule C just as they would be for a corporation. Personal expenses are not deductible in either case.

What if you operate your business out of your home? This is a tricky area, but deductibility is not determined by your form of business -- sole proprietorship, partnership, corporation, etc. For more information regarding home office deductions, see IRS Publication 587, Business Use of Your Home

Without proper planning, incorporating may increase your tax liability. Although the corporate income tax rate on the first $50,000 of income is 15%, this rate is in addition to the personal income tax rate. If a corporation earns $10,000 in a given year, the corporation will pay income tax of $1,500. If the corporation then pays a dividend of the remaining $8,500, the shareholders will pay income tax on the dividend, resulting in double taxation of the corporate earnings.

If the corporation instead pays the owner a bonus of $10,000, the corporation will pay no income tax, but the employee will pay income tax. In addition, the employee and the corporation will pay payroll taxes. The taxes on compensation from a corporation are essentially the same as on earnings from a sole proprietorship. (You may have heard statistics that a large percentage of corporations pay no income tax. For many small corporations, this is because they distribute all of their earnings to the owners in the form of salary. The owners then pay income taxes on the earnings.)

What about state income taxes? If you incorporate in Nevada, which has no state income tax, will you reduce your Illinois tax liability? It depends. If you take the earnings out of the corporation in the form of salary or dividends and you are a resident of Illinois, then you will pay Illinois income tax on those distributions on your personal income tax return. In addition, if your corporation does business in Illinois, it will need to register with the Illinois Secretary of State and pay Illinois income tax on the portion of its income that was earned in Illinois.

Some of the incorporation companies also tout Nevada as a great state in which to incorporate because the names of shareholders are not public record in Nevada. This may be advantageous for non-tax reasons, but it cannot help you legitimately reduce income taxes. If you are trying to illegally hide income and evade taxes, a Nevada corporation should not be much help. The corporation will need a tax identification number to open any bank or brokerage accounts. All interest income, dividends, capital gains and proceeds of sales of securities will be reported to the IRS on 1099s. The IRS then uses a matching program to verify that all 1099 income has been reported. If your corporation does not file an income tax return or files an incomplete income tax return, the IRS will come to your door. They will be able to obtain shareholder information from the state of Nevada. They also have broad subpoena powers to obtain information from other sources. As with all tax evasion, you may think you are getting away with it for a while, but eventually you will probably be caught and faces huge fines and possibly jail time. (Remember, Al Capone went to jail for tax evasion, not murder.)

As for the National Audit Defense Network, the Justice Department has recently filed a civil lawsuit against it for tax fraud. A Justice Department press release dated April 14, 2004 states, "The suit also alleges that NADN sells a sham home-business tax scam, telling purchasers that, by starting purported home-based businesses they can deduct the cost of such non-deductible personal expenses as meals, travel, and housing. Court papers also allege that NADN misleads prospective customers about the tax savings that can be obtained by having NADN help the customers set up Nevada corporations."

What's the moral of the story? Get your tax advise from a reputable source. Read the IRS publications (believe it or not, they are generally easy to understand) or consult a licensed CPA or attorney. Go to Nevada for fun.
Posted in: June, 2004
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