Corporations
The following discussion is designed to assist you in your decision of whether or not to incorporate.

An attempt has been made to set forth the various advantages and some of the limitations to the incorporation of a business organization. Some of the items discussed may not be personally desirable to you, but, for the most part, the various items are available for your consideration in deciding whether you will incorporate.

The first items to be discussed are non-tax aspects of incorporation which should be considered by you in deter­mining whether to incorporate.

1. Shareholders risk only the money or other assets which are invested in the stock of the corporation. They are not personally liable for corporate obligations. This differs from a partnership in that the partners are jointly liable on claims arising from the acts of any partner within the scope of the partnership business.

2. An interest in a corporation (shares of stock) can be easily trans­ferred.

3. Incorporation allows avoidance of marital property rights in the conveyance of property, especially real estate conveyances.

4. The corporation has a perpetual existence. Con­sequently, a corporate business continues without the difficulties to which a partnership or sole proprietorship is subject when a participant dies or withdraws.

5. A corporation's credit can be kept separate from that of the owners of the business.

6. Corporate shares are more readily usable as col­lateral for borrowing than are partnership interests.

7. Shareholders in a corporation are able to retain anonymity more easily than can members of a partnership.

8. Organized securities markets are accustomed to dealing with corporate securities, thus making them easily transferable.

9. An owner of a business may incorporate so that he or she can become an employee of the corporation and thus qualify for social security benefits and other employee benefits.

10. The shareholder's voice in management is in proportion to his or her investment share. This differs from a partnership, in which case, the voice in management is usually equal between all partners.

11. A corporation can usually attract investors and accumulate capital somewhat more readily than a partnership.

Situations that reduce the benefit of the above advantages may occur. For instance, creditors, and especially banks and other lending institutions making loans to the corpora­tion, may require the participants of a close corporation to assume personal liabilities for the corporation's obliga­tions in order to obtain needed resources for the business.

Also, the act of incorporating always entails filing certain formal information with the Secretary of State, such as the Articles of Incorporation. Thereafter, Annual Reports must be filed with the Secretary of State. The corporation must file separate tax returns.

If a separate corporate entity is not respected and all formalities involved with the corporation complied with, the benefits of incorporating may be lost. Failure to follow these requirements could cause the shareholders of the corporation to be liable for the corpo­rate liabilities and advantageous tax benefits could be lost. Corporations are not entitled to the various exemptions from claims of creditors allowed under Iowa law to individuals, such as homestead exemption and various exemptions for personal property which include farm machinery and equip­ment, livestock and tools of the trade. All property of the corporation is subject to the claims of creditors.

Corporations are not entitled to homestead or military property tax credits or exemptions. The following items are tax aspects which must be considered when deciding whether to incorporate:

1. Corporate income tax rates are in many cases lesser in amount than individual income tax rates. Corporate income tax rates are only 15% on the first $50,000 of net taxable income, 25% on the next $25,000, and 34% on all net taxable income over $75,000. No social security tax is paid on income retained by the corporation. The top taxable rate of the corporation, which runs between 34% and 39%, is more than the top rate of an individual, which runs between 28% and 35%. In addition, corporations, on taxable income in excess of $100,000.00, pay a 39% rate until it reaches a taxable income of $335,000.00 at which time the rate returns to 34%.

2. Qualified pension and profit-sharing plans produce tax advantages for the corporation when they are implemented for the employees. The plans operate by establishing a trust into which the employer pays an agreed amount per employee per year. On the retirement of the employee, he or she is entitled to have a proportionate share of the available proceeds. Within certain limitations and restrictions as established by law, the qualified pension and profit-sharing plans generally allow the following:
A. The employer may deduct his or her contribution to the plan in the year that they are made. B. The employee is not taxed on the money allo­cated to his or her benefit until he or she actually receives a distribution from the plan. C. The pension or profit sharing fund can accumu­late its earnings free of tax.
These tax advantages are not completely unlimited. One of the requirements of the Internal Revenue Code is that the plan must be "non-discriminatory," that is, it must not be drafted or operated in a manner which discriminates in favor of officers, shareholders, supervisors, or highly compen­sated employees. There are specific requirements which the Internal Revenue Service has set forth which the corporation must meet in satisfying the non-discrimination standard. These requirements basically amount to including most of the employees in the operation of the plan. A further limita­tion is the amount which the corporation can deduct for contribu­tions to pension and profit sharing plans. Ordi­narily, the deductible amount is limited to what is regarded as "reason­able" compensation for services rendered. This limitation is to prevent the use of the plan as a subterfuge for dis­tributing profits to shareholders. Even further limitations apply to a "S" corporation.

3. There are various deferred compensation plans that can be used which do not have to be qualified under the Internal Revenue Code and which can be discriminatory in favor of officers or other highly compensated employees.

4. Shares in a corporation can be the subject of Buy-Sell Agree­ments whereby on a shareholder's death, his or her interest is purchased by the other shareholders or the corporation. Often these, or death benefits under an employment agree­ment, are funded in whole or in part by life insurance owned by the corporation which may have more favorable tax conse­quences than personal life insur­ance. This plan operates by having life insurance held by either the corporation or by the other shareholders on the life of each shareholder (or the lives of certain key shareholders) pursuant to an agreement whereby the estate of the decedent shareholder is required to sell its shares to the holders of the insurance policies. Advantages are the insurance proceeds are tax free to the beneficiary; the estate is able to sell its shares (which may not otherwise be marketable) to other individuals who are already part of the business (outsiders are not introduced) and who other­wise might not be able to afford to buy the shares. Conse­quently, the estate will receive necessary money to pay taxes and other estate costs, whereas, the main assets before the sale were shares in the corporation. One limita­tion on life insurance and Buy-Sell Agreements is that the premiums are not deduct­ible by the corporation. However, the premiums upon term life insurance policies for each employee up to $50,000 face value are deductible by the corporation and tax free to the employee.

5. Restrictions can be placed on stock transfer and the value of the stock can be set each year so that the value of the stock can be controlled for estate planning purposes.

6. The corporation-employer may pay the employee's estate or beneficiary an amount of up to $5,000.00 in death benefits. This amount is received income tax free. How­ever, the corporation still gets to deduct the $5,000.00 payment.

7. An employee may be the recipient of tax free health and accident benefits. The costs of these benefits are deductible to the corporation.

8. An employee may be the recipient of tax free group term life insurance plans which can be established to avoid estate tax on the benefits. The plans are income tax free to the extent that the face value does not exceed $50,000.00. The cost of these particular life insurance plans are deductible to the corporation.

9. Tax may be deferred on compensation paid to the employees if the payment of the compensation can be de­ferred. This is possible where the corporation is on the accrual basis and the taxpayer-employee is on the cash basis. The corporation may deduct the wage when it is due (in December, for instance) and it would not be taxable to the employee until he or she receives the compensation, which can be in January, for instance. This allows the employee to have less income in a year in which he or she might be in a higher bracket, and more income when he or she might be in a lower bracket.

10. A corporation allows a leveling of income to the shareholder-employee so that the amount paid to the share­holder-employee is approximately the same each year. For instance, the income of the business may be high in a good year, but a loss may be suffered in a bad year. The cor­pora­tion will be taxed at a steady rate. Consequently, by setting a steady salary for the shareholder-employee, their income does not vary so as to cause changes in their per­sonal tax brackets. At the same time, the corporate income will vary, but within the specified limits, the corporate tax bracket will not change. If the corporation is thrown into a loss position, this can be compensated for by the net operating loss carryback and carryover provisions.

11. An employee is not taxed on amounts paid by the corporation to reimburse him for medical and dental ex­penses, including insurance premiums for himself, his or her spouse, and dependents, or to pay such expenses and premiums directly, but only if he or she does not deduct them on his or her per­sonal income tax return. Such medical reimbursement plans must be non-discriminatory, i.e., available to all employ­ees. Medical reimbursement expenses are fully deductible to the corporation and tax free to the employees. These plans are not available to "S" corporations.

12. An employee is not taxed upon a prepaid legal plan or upon a legal reimbursement plan although such expenses are deductible to the corporation even though the legal services are rendered directly to the employee.

13. Qualified and restricted stock options provide certain tax advantages to the corporation. There are employee stock option plans which can be very beneficial.

14. Dividends declared by the corporation to a corpo­ration shareholder are subject to an 70% exclusion, which means that only 30% of the dividend is taxable to the receiving corporation, provided that the receiving corpora­tion owns less than 20% of the stock of the paying corpora­tion. A dividend declared to the parent corporation by a wholly owned subsidiary corporation is tax free to the parent corporation.

15. Certain losses from passive activities, such as rental losses, are not deductible by an individual against their earned income. These restrictions do not apply to corporations.

16. One very imposing limitation of incorporation is the double taxation of income that occurs. Double taxation occurs because of the fact that the corporation itself is an entity and must pay income taxes, but the dividend payments to shareholders are not deductible to the corporation. Consequently, when the shareholder receives his or her dividends, he or she again must pay income taxes on the dividend. Within certain limitations, double taxation of income can be avoided by employing the share­holders. This avoids double taxation because the share­holder-employee's compensation is deductible to the corpora­tion as an expense. This also allows compensation of an optimum salary which would result in the least amount of tax for both the corporation and the shareholder-employee.

17. Various methods exist for taking money out of the corporation which enable the shareholders to avoid the double tax which occurs when the corporation's income is taxed and the dividends are taxed again in the hands of the shareholders.
A. Shareholder-employees may draw reasonable compensation for their services to the corporation as discussed above.

B. The corporation may elect to qualify under the Internal Revenue Code as a "S" corporation; and if it meets the requirements, it may distrib­ute the earnings of the corporation to the share­holders. Therefore, earnings will be taxed only once in a manner similar to a partnership. This allows corporations with income of $100,000.00 or more to be able to be taxed at the lower maximum rate for individuals of 33% as opposed to the higher maximum corporate rate of 39%.

C. Shareholders may make loans to the corpora­tion and draw money out as interest. D. Property may be leased to the corporation and earnings drawn out as rent. E. Property may be sold to the corporation. This is perhaps the least reliable method.
In subparagraphs A, C, D, and E above, the amounts received must be reasonable.

If you desire to sell some or all of your shares of stock, legal counsel should first be sought in order that you do not violate any federal or state security laws. Also, the most beneficial income tax consequences should be considered before you sell or exchange your stock.

Upon liquidation of a corporation, it is possible that both the corporation and the shareholders will each have to pay additional income tax. Therefore, any liquidation should be carefully planned with your attorney and/or tax adviser before you do anything.

This letter is based upon existing tax laws and as the years go by, Congress may change the tax laws and the state legislatures could change the corporate laws. Therefore, as time passes, the content of this letter should be reviewed as to its accuracy. Further, all laws which impact corpo­rations and income tax impact to corporations have not been discussed in this letter.

Your attorney and/or tax adviser should always be consulted. Your corporation must have a meeting of shareholders and directors at least annually, as this is required by State law.

When you sign corporate checks or documents on behalf of the corporation, you should always state your position after your signature (for example: John Doe, President), so that you are not personally responsible for the corporation's check or the corporation's act because of the manner in which you signed your name.

I hope that the various aspects of the corporations listed above will be of assistance to you in deciding whether or not you would like to incorporate. If I may be of any further assistance, please feel free to contact me at your convenience.