How
To Save Thousands of Dollars a Year in Taxes by Incorporating Besides
protecting your personal assets, incorporating may slash your overall
tax bill too!
Someone
once remarked, “Next to being shot at and missed,
nothing is quite so satisfying as an income tax refund.”
There’s no question that saving money on taxes is high on
everybody’s list of financial priorities---especially self-employed
business owners.
However,
unlike individuals who work as employees, business owners actually
have
the “luxury” of choosing how much in
taxes they pay each year by picking one form of business entity
over another---such as a sole proprietorship, partnership, corporation,
or limited liability company.
Unfortunately, the majority of business owners choose a business
entity once---usually when starting out---then keep the same entity
for the life of the business.
This
isn’t
necessarily always the smartest thing to do.
While some companies can get away with sticking with the same
form of business entity throughout the life of the business, countless
others are just throwing money away by paying more in taxes than
they have to.
For some smaller business owners, this financial nonchalance can
actually cost an extra several thousand dollars in unnecessary---and
avoidable---taxes each and every year.
If
you're a business owner concerned about reducing your tax liability,
here’s a way you can dodge the tax bullet by utilizing what’s
known as a Subchapter S corporation:
First some background:
When
starting a new business most entrepreneurs focus on simplicity:
that is,
the less paperwork and regulations to contend with the
better. What this means is that most new businesses start out as “unincorporated” entities
such as sole proprietorships (73%) and partnerships (6%).
While management and administrative costs of running the business
might be easier and less expensive initially, the tax burden---especially
the self-employment tax---can be anything but.
For many business owners who wait until year-end to do their tax
planning---or who do no tax planning at all---the self-employment
tax is an unwelcome surprise---and a very large expense.
Newly
self-employed individuals are shocked even more once they realize
that they're
responsible for the self-employment tax all
on their own. That’s because when they worked as an employee
their employer was responsible for paying one half of the self-employment
tax.
Self-employment tax particulars:
The
self-employment tax is simply a version of the same Social Security
and Medicare
taxes you pay as an employee. However, instead
of paying 7.65% as you do when you’re an employee, as a self-employed
business owner you have to pay double: 15.3%.
In 2004, the Social Security portion (12.4%) is levied on the
first $87,900 of net profits. There is no limit to the Medicare
portion (2.9%).
Self-employed individuals are also entitled to a one half-credit
of the tax.
As an example, a self-employed individual with $100,000 in net
profits in 2004 would be required to pay approximately $12,766
in self-employment tax.
NOTE:
This tax is in ADDITION to federal, state and local taxes!
HERE’S WHAT YOU CAN DO TO SAVE MONEY ON THE SELF-EMPLOYMENT
TAX:
Incorporate
and elect Subchapter S status. You can elect Subchapter
S status even if you have a pre-existing C corporation.
Operating your business as an S corporation is one of the very
few four leaf clovers still left in the tax code. The reason for
this is simple: The net income from an S corporation is NOT
currently subject to the self-employment tax.
If structured and implemented properly, an S corporation could
save you thousands of tax dollars per year. As an employee-shareholder
of your S corporation, you pay yourself wages just like you would
any other employee.
But
instead of taking profits out through payroll, you take cash
distributions called nontaxable dividends.
Nontaxable
dividends are called nontaxable, because they aren’t
double taxed like the dividends paid to shareholders in a regular
C corporation (although beginning in 2008 most dividends will no
longer be taxed).
You’re
still paying taxes on the net income of your S corporation when
you file your personal tax return, but the tax is federal
tax and not the self-employment tax.
For the sake of simplicity, if an S corporation with $100,000
of pre-tax and salary profits pays its owner a reasonable salary
of say $50,000 and non-taxable dividends of $25,000, the tax would
be $7,650.
This is a whopping $5,116 savings in tax compared to
the $12,766 a sole proprietor would pay on profits of $100,000!
Even
if you factor in additional costs such as workman’s
comp insurance, incorporation costs, professional fees and incidentals,
the savings is still more than adequate.
CAVEATS:
The
key to successfully implementing this strategy is that your salary
must
be REASONABLE under the circumstances surrounding your
business. It’s also much better for salary justification
purposes if your business is not limited to the delivery of personal
services by you.
At personal income levels close to the Social Security wage base
($87,900 for 2004), the benefits of using this strategy diminish.
BUT HERE’S SOME MORE GOOD NEWS:
If
you happen to already own a regular C corporation and you live
in a state
that has a high corporate income tax rate and a low
personal one, you’ll come out ahead even more if you elect
S status.
Additionally, if you have children aged 14 or older, you can save
even more taxes by giving them shares in your S corporation and
having them pay the tax at their lower tax rates.
By giving away shares you also reduce your estate tax obligation.
So
you see, there are plenty of good reasons to incorporate and
elect S status.
I’ve only touched on a few minor points.
Just keep in mind that you should ALWAYS consult with your tax
advisor and attorney before making any important business or financial
decision. Your financial situation is unique and this information
may not be appropriate for your particular situation.
Always look before you leap.
When it comes to your business, you should make it a point to
assess the validity of your type of business structure on a yearly
basis.
Incorporating
is definitely not just for startups. There are plenty of unincorporated
businesses that are missing the boat when it
comes to saving money. Don’t be one of them.
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If
you'd like more information or would like to discuss this
article personally with me, please write to
me at alex@goldminetactics.com
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below for author information.
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