If you heard that incorporating your business leads to business tax savings, be prepared to understand the cause in order to enjoy the benefits. The business tax savings aren’t automatic after forming a corporation. There are rules to follow.
First, let’s consider how the business tax savings occur. Income tax is determined differently on corporate profit than business profit of a self-employed proprietor or independent contractor. When you own a corporation, you’re not considered self-employed.
Instead, a corporation is a separate legal entity. It pays for the services of employees – including services you contribute to the corporation. By working for the corporation, you become an employee in addition to being a shareholder.
Consider the implications of this. Your first thought should turn to the costs involved, particularly if you are the only worker in your business. By incorporating, you now have to conduct a payroll process. This means withholding and remitting payroll taxes on your own wages.
When you’re self-employed, there’s no withholding of taxes on the money you pay yourself. You simply owe taxes on business profit. In addition to regular income tax, you also pay self-employment taxes. That’s the tax covering Social Security and Medicare for self-employed individuals.
When you’re a wage earner at your own corporation, Social Security and Medicare taxes are deducted from your paychecks. Plus, your corporation pays a matching amount of these taxes. So the combination of the employee part deducted from your paychecks and the employer part paid from corporate funds costs you the same as the self-employment taxes.
However, only your wages from the corporation are subject to Social Security and Medicare taxes. The business profit that’s not received as wages is exempt from these taxes. This raises the question of how to put in your pocket the profit you don’t receive as wages. That depends upon the type of corporation.
There are two types of corporations – C corporations and S corporations. The profit of a C corporation is taxed on a corporate tax return. In order to obtain money from the C corporation, you must receive either wages or dividends. Wages are a corporate expense that reduces taxable profit. Of course, you incur personal income tax on the wages. You also owe tax on dividends you receive. However, dividends aren’t a tax-deductible expense. They are taxed first as corporate profit and are then taxed again as your personal dividend income.
Avoiding the double taxation of dividends is where S corporations are used. The profit of your S corporation is taxed on your personal tax return. Distributions are not taxed like dividends from a C corporation. This tax situation is just like an unincorporated business – except there’s no self-employment tax on corporation profit. Remember, you only owe Social Security and Medicare taxes on wages you receive. Plus, distributions of S corporation profit are not taxed as dividends.
In exchange for this tax benefit the IRS requires S corporation shareholders who work for their companies to receive “reasonable” wages. You can measure the tax savings of incorporating based upon your business profit. Higher profits mean more money for distributions after paying yourself a reasonable salary.