Percheron Hill LLC: Small Business Articles

Avoiding Small Business Incorporation Scams

Incorporating a business often makes good legal and tax sense. Absolutely.

But new entrepreneurs need to know that a handful of incorporation scams often ensnare small businesses. And that's terribly unfortunate. Getting entangled in an incorporation scam always creates headaches, usually wastes money and may even cause you to inadvertently break the law.

Scam #1: Incorporating for Automatic Tax Deductions

The first incorporation scam? Incorporating because someone (often an off-base consultant or business coach) tells you that incorporation means you'll be able to magically turn personal expenses like cars and travel into business deductions.

The reality sandwich is this: Incorporation does not automatically produce tax savings, and incorporation does not automatically convert personal expenses to tax deductions.

The general rule--which works for sole proprietorships, partnerships, regular corporations and S corporations--says that any ordinary and necessary business expense can be deducted. Personal expenses, in comparison, can not be deducted.

One related point should be made, too. The tax accounting rules for entities do differ. For example, sole proprietorships have some tax planning tricks that can sometimes make them the best entity choice. So do partnerships and corporations.

You definitely do want to consider the tax features of the various entity choices you have available. A corporation (either a regular C corporation or a Subchapter S corporation) might, in your specific case, be optimal. Or perhaps a partnership might be best for you. You should probably carefully check out your options.

But incorporating a business for automatic extra tax deductions, well, that's really just a scam.

Scam #2: Incorporating in Nevada to Avoid Your State's Corporate Taxes

The second incorporation scam is incorporating in Nevada (or incorporating in some other no-corporate-taxes state) to avoid your state's taxes.

The Nevada scam promises na´ve business owners that incorporating, say, a California business in Nevada will mean the business doesn't have to pay California state corporate income and franchise taxes. The scam sometimes also promises that the business owner will avoid having to pay personal state income taxes.

Anybody who suggests that this scam works is either an idiot or a criminal... or maybe both.

Two problems exist with the Nevada incorporation scam. Problem one is that if your Nevada corporation does business in, say, California, you still have to register your corporation with California. That registration means you will have to pay any state franchise taxes.

Problem two? If a corporation earns profits in a state, that state gets to tax those profits. If a Nevada corporation in actuality operates in California, for example, all of the profits are subject to California income taxes--regardless of where the corporation was formed.

Note: I describe how states apportion business income among the states where a business operates at my CPA firm website. Click the preceding hyperlink for details.

The bottomline? Make sure you don't incorporate in some other state because you think that will let you avoid paying taxes to the state you actually live and work in. The incorporate-in-Nevada scam amounts to state tax evasion, pure and simple.

And by the way just to make this point: If you're a Nevada business? Of course you should incorporate in Nevada. Nevada incorporation, for Nevadan businesses, is the right state.

Note: Scam #1 and #2 are actually pretty serious problems to get caught up in. Both scams, once you know the law, probably amount to criminal tax evasion.

Scam #3: Paying for Registered Agent Services in your Home State

Scam #3 amounts to only a minor if costly annoyance: paying someone to be your registered agent in your home state.

Here's the deal with registered agents. The state where your corporation operates wants to know the name and contact information for a real person. In other words, the state wants a real human being the state can contact if it has questions and to whom the state can send correspondence. The contact is called a registered agent.

Incorporation services sometimes pitch you the idea they should be your registered agent--often charging $100 to $200 a year for the service. But you don't need this service if you, yourself, live in the state where you're incorporated. You can be your own registered agent.

As the registered agent, you'll be the person to whom the state sends its letters. And your name and address will probably be available online at a state web site as the contact information for the corporation. But if you're in business, you shouldn't have a problem with people (customers, clients, potential customers and clients, and so forth) knowing who you are and where to find you. And you shouldn't pay potentially thousands of dollars in registered agent fees over the life of your business.

About the author: Seattle, Washington certified public accountant Stephen L. Nelson provides CPA services to small businesses and individuals with complex financial affairs.