Last week I came home from a golf tournament.  I bragged to my wife that I won $80 in cash.

She asked me how much it cost to enter the tournament.

Once again she burst my male ego.

Another example of how wives just don’t get it.

So today we’re going to  talk about bursting some tax balloons.

  1. Incorporation

We all know about corporations. Someone starts a business and works real hard at it for a long time. The business becomes successful, starts making money, and it  increases  in value. There may even be some goodwill being developed—a good name, location, special way of doing things—that would have value to a buyer.

So the business person consults with his or her attorney or accountant and decides to incorporate the business, in part to shelter themselves from the claims of creditors.

The business person hires someone to form a corporation (or an LLC that elects to be treated as a corporation). This can often be done inexpensively online or through any number of do-it-yourself kits. I have seen enrolled agents do it over the telephone.

This is a very common situation. Unfortunately, it is fraught with peril.

One of the problems with a “simple” incorporation is that it can easily become a taxable event. That’s right, just the act of transferring a business to a corporation can create an immediate tax bill. I’ve represented countless businesses that did the “overnight” incorporation on the advice of someone unaware of the tax rules, only to be forced into a huge tax bill for doing it improperly.  These tax advisors are foolish, incorporation must be carefully done or it can really become expensive .

And don’t think the IRS won’t audit you. Unlike most routine business transactions, incorporation requires disclosure on both the corporate and individual tax returns.

Another problem with “simple” incorporations is appreciated assets.  Normally we can sell our business and pay one capital gains tax.    But if the corporation sells the assets, it often pays a  tax on the gain. These funds may then be distributed to the owner, where a second tax is imposed on them.  Thus  a sale that normally yields one capital gain tax to the original business owner  may actually result in two taxes and they may not be capital gains at all.

Both the tax on incorporation and the double tax on sale can be avoided or minimized if the first incorporation had been handled properly.

  1. Passive Losses

Another problem with incorporations is passive losses.

Attorneys are quick to form an entity to protect business persons and their assets from creditors. Estate planners are quick to divide businesses into pieces to shelter the valuable assets from those that may generate lawsuits, especially  in the hope of getting discounted values for estate tax purposes.

This can be real dangerous. Here’s why. A typical business may conduct its  business  in a building. The accountant or attorney  may want to shelter that  building in a separate entity and lease it to the business. This lease generally creates a loss, and under the passive activity rules this loss may be non-deductible. As  the business income may be active, it will not offset that rental loss.  So the business owner went from $100 in income to $120 in income and a $20 nondeductible loss.  This can be very complicated and I’ve had many cases on this issue—some of which ended up in  federal court.

Folks, this is not the most interesting article I’ve written. But it may be one of the most important.  If you intend to transfer all or any part of your business to a corporation or LLC, please understand that this can be a complicated area of tax law , make sure your representative knows  what you are doing,  and that you consult with someone familiar with the tax consequences in doing so-which  can be severe.

I wish I could make a living playing golf, instead of embarrassing myself in these tournaments and at home.