Incorporation?

by Nicholas Walsh, PA

If you own a small business - and that includes commercial fishing operations – you’ve probably considered whether to incorporate. This is a dry subject, but important. I’ll try to keep it painless.

When a business is incorporated, a new legal person is created. This is done by recording some documents with the Maine Secretary of State and paying $145.00. Many lawyers provide the service, and the fee ranges from maybe $450.00 to $1,000.00, generally higher if a big firm is doing the work. It’s not complicated but it demands attention to detail and an understanding of the business being incorporated and the owners’ concerns.

There are two big reasons to incorporate: to prevent liabilities of the business from becoming your personal liabilities, and to save money on taxes. Incorporation may also make it easier to sell or pass on the business.

In a corporation, the assets and the liabilities of the business belong only to the corporation, not to the owner or owners of the corporation. That’s why if I own ten shares of General Motors, I can’t be sued if GM doesn’t pay for its steel. And that’s why if I own the shares of F/V Highliner, Inc., I can’t be sued if F/V Highliner, Inc. stiffs its fuel dealer.

What if, through carelessness or other negligence, someone is hurt on board? The injured person can go after the boat, he can go after the other assets of the corporation, but he can’t go after the shareholders. When I am advising a client who is involved in a business where someone could get hurt (which is any business), the first line of defense is a good insurance policy. The second line of defense is incorporation, critical if the policy won’t pay or isn’t enough.

There are exceptions to the rule that the liabilities of a corporation are not those of the shareholders. The most important exception isn’t really an exception at all. Suppose I am sole shareholder of Mom and Pop, Inc., whose sole asset is a convenience store. I’m there from six to six, and in cold weather one of my thousand jobs is to mop the floor in front of the door. One day I ignore the puddle and a customer slips and is hurt. Am I liable? Sure – I’m the guy that was supposed to mop the floor, and I carelessly failed to do so. So Mom and Pop, Inc. gets sued, but so do I, as the individual who had a duty and breached it.

But suppose I wasn’t in the store that day, and the kid I instructed to mop the floor slacked off. Do I get sued? No, because I didn’t do anything wrong.

Bottom line, a corporation won’t protect you for being sued for things you personally do or fail to do. It will protect your personal assets from things your employees do or fail to do.

The right to do business through a corporation is a privilege granted by the state. If, using the corporation, you cheat or defraud someone, don’t expect the corporate shield to hold up.

You need to make sure vendors and customers understand they are dealing with a corporation, not with you as an individual. Don’t mingle your personal money with the corporation’s. Keep a separate bank account for all corporate funds, and make sure the checks have only the corporation’s name. Use letterhead, invoices, business cards, sign etc. that conspicuously bear the corporation’s name. Sign letters, contracts etc. as “President, XYZ, Inc.”

Here’s an important one: Don’t start using a name that is different from the name on file with the Secretary of State! Surprisingly often I encounter a situation where the corporation was filed as, say, “Al’s Restaurant, Inc.” and a few years later that’s morphed into “Al’s Sandwich Shop”. Al’s vendors could easily argue that they looked up “Al’s Sandwich Shop” with Maine’s Secretary of State, found no corporation with that name, and therefore reasonably assumed that they were dealing with Al personally, doing business as Al’s Sandwich Shop. (A corporation can use other names, but it has to register them with the Secretary of State.)

Rule of thumb: Don’t give the public any reason to believe it is dealing with you personally rather than with your corporation. If you want to incur personal liability – say to get a bank loan, by signing a guarantee – do it deliberately, not by mistake!

Finally, attend to the few corporate formalities Maine requires. An annual report must be filed by June 1 of each year, or in August the corporation will lapse. If that happens there will be no corporate shield between you and creditors or plaintiffs. There are a few other requirements, not many. Consult a lawyer.

Doing business through a corporation can save you taxes, too. Here’s the math. Suppose I take $100,000 a year out of my business. If I’m self-employed, I have to pay both the employer and the employee share of Social Security and Medicare (“FICA”) on all that income. The employee share of Social Security is 6.2%, and Medicare is 1.45%, for a total employee FICA tax of 7.65%. The employer’s share is the same. Because, if I’m unincorporated, I am both employer and employee, my total FICA liability is 15.3%. In short, if I’m not incorporated I’ll pay $15,300 in FICA taxes on my $100,000 income, before I’ve paid a penny in regular income tax.

Let’s suppose my business is incorporated and that I’ve told the IRS that I want it to be treated under “Subchapter S” of the IRS code. (The sub-S election means the corporation itself does not pay taxes, although it files a tax return; instead the shareholders pay personal income taxes on corporate profits, pro rata by share ownership.) The corporation can pay me a “reasonable salary” for my job – let’s call it $60,000. I can take the other $40,000 out as a dividend. Just as I don’t pay FICA on dividends from my GM stock, I don’t pay FICA on that $40,000 dividend. (I do pay regular income taxes, of course.) The employer share of FICA is a deductible business expense, so it doesn’t matter, for my personal tax liability, if I reduce it: the employer’s FICA contribution just reduces the bottom line and thus reduces the taxable profits. The employee share of FICA, on the other hand, is a check I have to write from my personal checking account, one I cannot deduct from the business to reduce taxable profits. Because I’m incorporated, I will pay an employee FICA contribution of $4,590 (7.65% of my $60,000 reasonable salary). If I were not incorporated, I would pay FICA on the entire $100,000, for an employee FICA contribution of $7,650.00. So by being incorporated I save $3,060, every year.

This is a genuine loophole. In Congress and the IRS, there’s constant chatter about doing away with the ability of a sole shareholder corporation to designate some of the corporation’s income as dividends and thus reduce the shareholder’s FICA liability. So far the law allows it. Bear in mind that the “reasonable salary” must be defensible if the IRS questions it – consult your accountant on this, and before deciding to incorporate.

Next month I’ll discuss various alternatives to a corporation, such as the Limited Liability Company, or LLC.

Nicholas Walsh is an attorney specializing in maritime law and waterfront matters. He can be reached at 772-2191, or nwalsh@gwi.net.