Economic and Marketing Information
FOR INDIANA  FARMERS
Prepared by the Agricultural Staff of Purdue University, Lafayette, Indiana
July 31,  1970
To Incorporate or not to Incorporate: Federal Income Tax Implications
by Floyd E. Gillis, Associate Professor of Economics,
and Robert C. Suter, Associate Professor of Agricultural Economics
The decision as to whether to
incorporate a farm business depends at least in part upon the
rules regarding and the desire to
minimize income taxes and thus
the disposition of profits. When
a farm business is operated as
an individual proprietorship (or
partnership) all profits are subject to the personal income tax.
However, when that same business is incorporated, only the
salary paid to the owner or manager is subject to the personal
tax; the rest, typically referred
to as reinvested earnings, is subject to the corporate income tax.
When the personal tax rate is
lower than the corporate tax
rate, incorporation is not practical ; furthermore, if there are
no earnings to be reinvested, incorporation of course makes no
sense.
Yet today most well-managed
farms either have opportunities
for expansion and/or debts that
need retiring. Most farm operators can set up the records relative to their farm business so
that all payments which accrue
to owner or owners can be in the
form of a salary or salaries. If
these two ideas are not realistic,
consider them as assumptions,
for purposes of the following
analyses.
The first idea—the opportunity for expansion and/or debt
retirement—"eliminates" the
problem of a tax being levied on
improperly accumulated surpluses. The second idea—owner
payments in the form of salaries
rather than profits—eliminates
the problem of "double taxation"
first on corporate profits and second on dividends to the owner or
owners.
Tax Rates:   Personal versus
Corporate
Both personal and corporate
income tax rates are graduated
(the corporate rate more so).
The personal rate graduation or
(or rates) for 1969 numbered
24 and ranged from 15.0 to 70.0
per cent. The corporate rates for
1969 consisted of a 22.0 per cent
normal tax (on all income) plus
a 26.0 per cent surtax (on all income over $25,000) ; thus really
two rates—22.0 and 48.0 per
cent.
A direct comparison of tax
rates is not relevant, however.
It is the additional tax along
with the method of "disposing"
of the income that is important.
For example, a farmer with a
$40,000 income in a direct comparison pays $560 less taxes if
he pays them personally ($12,-
140) than if he pays them as a
corporation ($12,700). See Table
1. Yet, if this same farmer incorporated, he could allocate his
$40,000 income between himself
in the form of salary and the
corporation (as reinvested earnings) so as to save $4,038 in
taxes. And, it's all perfectly
legal.
When to Incorporate
There are two conditions under which incorporation saves
federal income taxes:
1. Where the portion of corporate income which is retained
or reinvested in the business is
less than $25,000, and where
(INC x TRP) is greater than
TRS (INC x $SA) 4- .22 (INC
x 7fRE). The two taxes—personal and corporate—are equal
when (INC x TRP) = TRS
(INC x %SA) + .22 (INC x
%RE).
INC = total income to the
business or owner
TRP = tax rate on that income when all income is personal
income
c/c SA = percentage of corporate income taken
as salary
% RE = percentage of corporate income retained or reinvested in business
TRS = tax rate on that income which has
been taken as salary.