Can I Incorporate an Existing Business?

You can incorporate an existing business. For example, if you operate a sole proprietorship, you can incorporate that proprietorship, turning it into a corporation. Similarly, a partnership can incorporate--and thereafter operate as a regular C corporation or an S corporation.

You need to be careful, however, when you incorporate an existing business. More precisely, you need to follow some specific rules in order to avoid paying any income taxes because of the actual incorporation. In layman's terms, the rules state that you need to control the corporation after you incorporate, and that you can't offload too much debt nor any personal debt into the new corporation.

Incorporating a Sole Proprietorship

For the sole proprietor who incorporates and creates a one-person corporation, the control requirement is automatically met. The only things the proprietor needs to be careful about, therefore, are that he or she not contribute any personal liabilities to the new corporation. (Like credit card balances.) And that he or she also not contribute more liabilities than assets to the new corporation.

To explain the problem of excess liabilities, suppose you own a sole proprietorship with $100,000 bank loan (the only liability) and with $50,000 of raw land (the only asset). In this case, if you incorporate, you contribute $50,000 of excess liabilities to the corporation. And you, the incorporating proprietor, may end up paying tax on the $50,000 of excess liabilities you're relieved from.

Incorporating a Partnership

If more than one person incorporates a business--say a partnership incorporates--you still have to watch the rules about liabilities. And you also need as mentioned earlier to make sure that the people contributing stuff to the new corporation control the corporation after the incorporation.

Tax law defines the term "control." The laws say that for purposes of the tax-free incorporation rules, "control" means the people who incorporate own at least 80% of each class of stock. In the case where you're talking about an S corporation, only one class of stock exists. Accordingly, when incorporating to create an S corporation, the incorporators would need to make sure that the incorporating shareholders own at least 80% of the stock after the incorporation.

Practical Tips on Incorporating an Existing Business

A couple of final notes: If you want to get help from your accountant with the steps of incorporating an existing business, make sure your accountant is comfortable working with "Section 351 Transfers." Section 351 is the main chunk of the tax law that specifies how incorporation needs to work in order to not trigger income taxes.

And a second point to know about incorporating an existing business... You can give a proprietor or a partner stock in a new corporation for the assets or for the assets and services that they can contribute.

But you can't give them a stock solely for services they can contribute and avoid taxes. If you give someone stock solely for services she or he contributes, that transaction will be taxable to the recipient. Which makes sense, if you think about: In this scenario, you're essentially paying someone a wage using company stock.

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