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As a business owner, converting your sole proprietorship to a corporation can have tax advantages. When you’re ready to incorporate your business, the first thing you’ll need to do is prepare and file your corporate documents. You probably already guessed that paperwork needed to be filed, but hold on there—your business is not a corporation yet. Filing the required documents is not the only step in the process.
Filing incorporation documents creates an empty corporation. Your business, however, continues operating as it always has, as a sole proprietorship. For your business to fill that empty corporate shell, you have to move your assets over to the corporation in exchange for stock. Basically, when you are incorporating your business, it becomes its own entity rather than an extension of you. Here’s a tip: You don’t have to transfer all of the assets to the corporation. You can keep some under your name. In fact, it would be wise to consult your tax adviser about which assets are better kept in your name.
In the case that you maintain control of your corporation, the exchange of assets for stock is tax-free. How do you know if you control your corporation? For tax law purposes, “control” means that directly following the exchange, you own at least 80 percent of the combined voting power over all the stock and you own at least 80 percent of each of the stock classes without voting rights. This rule of the tax-free exchange always applies, regardless of when you form the corporation.
Be aware: Your family’s stock (including that of your spouse) does not count toward your 80 percent ownership. If, for example, after the exchange you own 70 percent and your spouse owns 30 percent, you do not meet the control criteria. That means you lose the tax-free exchange. Luckily, there are ways around this problem. Your spouse can join you on the transfer, such that both of you are contributing property for the stock. By making the exchange together, you qualify for tax-free status as a group.
Considerations When Doing Business with Your Corporation
Since your corporation is a separate entity from you, you have effectively created a new person for tax purposes. This means that you and the corporation do not share assets, and you cannot use each other’s assets without certain consequences. After all, you can’t just use your neighbor’s assets without compensating the person, right?
Here are some scenarios you’ll want to consider:
- Using Corporate Assets—What if you would like to use your corporation’s assets? You simply have to arrange the use like you would with any other unrelated business acquaintance. You can treat your borrowing of corporate assets like any of the following situations:
- A fringe benefit,
- A purchase,
- A lease,
- A dividend, or
- Any other economic arrangement business people might enter into.
You should be aware that because you control these arrangements between you and the corporation, the IRS will keep a close eye on the terms you arrange. If the IRS thinks you are mishandling such an arrangement or interchanging your assets with the corporation’s assets, it has the authority to reallocate your deductions, income, and assets in the manner it approves.
Usually, these reallocations will not be to your benefit. So, you need to protect yourself when dealing with your new corporation. That means documenting all your transactions and using fair market value terms to the best of your ability.
- Contributing Debt—When you incorporate your company, it’s not only assets that you can transfer to the corporation. You can also transfer your business debt, such as mortgages and outstanding loans. For tax purposes, this poses no problem; however, your creditors may have a different opinion.
For an asset tied to debt, such as an office building, you will probably need approval from the creditor before transferring the asset to your corporation. It’s not a big deal if you don’t get approval, though. You can always make arrangement with your corporation to compensate you for the use of assets still in your name (e.g., by paying rent to you).
- Dual-Purpose Assets—Even after careful doling out of assets, you will probably still have some items that you use for both business and personal uses. Your car is an example of these. In such cases, you will have to make your own reasonable decisions based on how the assets are used. The best strategy is to talk to your tax adviser about your options for dual-purpose assets.
When determining how to classify these dual-purpose assets, you may want to consider liability. Incorporating your business does a wonderful job of protecting your personal assets. This is because business creditors are then limited to dealing with the corporation’s assets.
- Handling Third Parties—When you transfer assets, some of those may have third parties involved. Any permits, licenses, or bank accounts, for instance, will need to be changed and put into the name of the corporation. They cannot remain under your name. It may cost money to make these changes, but by doing so, you avoid the cost of contract penalties and additional taxes. These costs are just part of changing your business over to a corporation.
This article gives you a good overview of how to handle incorporating your sole proprietorship. Now you know what to be thinking about (and documenting!) when it’s time to make the change. Good luck in your endeavors, and be sure to check with your accountant when it comes down to the nitty-gritty!
- The necessary documents and process for filing vary between states. ↑
- IRC Sections 351(a); 361(a). ↑
- IRC Section 368(c). ↑
- See Burr Oaks Corp., 43 TC 635, 651 (1965), aff’d, 365 F2d 24 (7th Cir. 1966), cert. denied, 385 US 1007 (1967). ↑
- IRC Sections 482; 7701(o). ↑
- IRC Section 357(a), (c). However, in some instances, you may recognize gain. ↑