As a general rule, you can incorporate your business with no tax cost as long as you contribute all of your businesss assets and liabilities to a corporation you control.

A sole proprietor who incorporates his or her business, therefore, should be able to incorporate tax-free. So should a partnership. And a limited liability company that makes an election to be treated as a C corporation or as an S corporation should also be able to make these incorporation elections tax-free.

But all rules, including general rules, can be broken. And when it comes to incorporating your business, three big tax traps await unwary business owners, managers and entrepreneurs.

Incorporation Tax Trap #1: Goofy Liabilities

If a shareholder transfers liabilities to a newly minted corporation and theres no business purpose to support all of the transfers or if the liabilities are transferred to avoid taxes, then all the transferred liabilities are treated as boot. And that can be a disaster because the boot can be taxed.

In general, liabilities incurred in the normal course of a businesss activities should easily pass the business purpose and no tax avoidance tests. But if you transfer personal liabilities to a corporation (like a personal credit card balance), youre in trouble. Similarly, if you transfer business liabilities that were really used to fund personal expenditures (like a business credit line drawn down to pay for a daughters college tuition), again, youre in trouble.

Incorporation Tax Trap #2: Excess Liabilities

If a shareholder contributes both assets and liabilities to the new corporation and the liabilities exceed the shareholders adjusted basis in the propertyeven if all the liabilities are legitimate business debts--the shareholder recognizes gain on the excess of the liabilities over the adjusted basis. And this is another easy trap to fall into.

For example, if your only business asset is a truck you bought and completely wrote off, its basis is zero. If you financed the truck with a $15,000 bank loan and none of the loan has yet been paid off, the liabilities exceed the adjusted basis of the truck by $15,000. In this case, incorporating triggers a $15,000 gain. Ouch.

Incorporation Tax Trap #3: Lack of Control

One other thing. You need to be in control of the business after you incorporate.

Often, control should not be a problem. If a sole proprietor incorporates her business, becoming a one-woman corporation, shes obviously still in control.

If a three-man partnership incorporates and after the incorporation, the business still has only the same three owners, the old partners still control the new business. So, again, no problem.

In situations where an incorporation means new owners are brought into the business, you need to measure whether the old owners own 80% of all the corporate stock in the new entity. If they do, no problem. If they dont, big problem: The incorporation is treated as if the old owners sold the old businesss assets to the new corporation for the fair market value of the stock received. If the adjusted basis of those assets is less than the fair market value of the stock, the incorporators will pay income taxes on the difference.

Closing Caveats

Two closing caveats: Incorporating a partnership and particularly a limited liability company thats been treated as a partnership can create some tax complexities that are way, way beyond this short article.

Also, the rules for incorporating a business in a tax-free manner are complicated if youll later move pieces of the business outside the US. For these reasons, if your incorporation plans involve a partnership or foreign operations, consult with a knowledgeable tax practitioner.