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26 July 2017

The Dire Consequences of “Accidentally” Incorporating

The Dire Consequences of “Accidentally” Incorporating

Online legal services make it seem very easy to start and incorporate a business. But, through the eyes of the IRS, the difference between a sole proprietorship and a corporation is more dramatic than just being able to add “Inc.” to your business name. A Michigan tax case involving a small family business illustrates this point. What started with an innocent mistake by a well-meaning son ended in thousands of dollars of back taxes owed by a widowed business owner. 

The business—a ticket sales company called Ultimate Presales—operated for years as the sole proprietorship of a joint-filing couple. They used personal credit cards to pay business expenditures, deposited income directly into personal bank accounts and filed income taxes on Form 1040 which, in 2008 and 2009, included losses for more than $40,000 each year. But in 2010, the IRS disallowed the losses because the business was considered a separate corporate tax entity. What happened?

As MarketWatch explains, “Unfortunately, one of the taxpayers’ sons incorporated Ultimate Presales in the state of Michigan in July of 2006, using an online legal service. This was done without the parents’ permission and while the son was still a minor. Not surprisingly, the son was unaware of the important tax differences between a sole proprietorship and a corporation. When the corporate paperwork from the state arrived in the mail, the husband (the proprietor) did nothing to unwind the unintended incorporation. In fact, he compounded the son’s error by filing annual corporate reports for Ultimate Presales with the state of Michigan.”

It seems like an innocent mistake made by a minor with no authority to make decisions for the business, so why did the court side with the IRS? It was because the father didn’t unwind the incorporation after it was discovered and, in fact, kept filing it as a corporation—which is all that is needed to keep it in legal standing and to disallow the personal deduction of losses in 2008 and 2009.

How you set up your business entity matters, not just when it comes to liabilities but also when it comes to taxes. Some individuals set up corporate structures so they can use “Inc.” in the name of the business or so they can call themselves a CEO. But corporations and sole proprietors are taxed very differently. Put serious thought into your business structure when you create it—from all angles. Talk to your tax advisor about the pros and cons of each structure you’re considering. And, certainly, hand over all business documents to your tax advisor—even if they seem to be irrelevant when it comes to taxes. Those documents may turn out to be a big deal after all. For more information, feel free to contact us.

 

Image Copyright: belchonock / 123RF Stock Photo


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