How Incorporating a Business Saves Taxes

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Tax is assessed on the profit of a corporation differently than the business profit of an independent contractor. Self-employed individuals receive a Form 1099 reporting their income as independent contractors. At high income levels, the tax rate for corporate profits is less than the personal rate. A tax savings is even realized when all the corporate profit is personally distributed to the owner.

There are two types of corporations—a regular C corporation and an S corporation. A regular C corporation files an annual tax return and is taxed at corporate tax rates. The highest corporate tax rates are usually lower than the highest personal tax rates.

However, in order to obtain money from the corporation, a shareholder must receive either wages or dividends. Wages are taxed at the shareholder’s personal income tax rate. This expense reduces the corporation’s taxable profit. Dividends are taxed at a lower rate, but are not a tax-deductible expense of the corporation. They have already been taxed as corporate profit and are then taxed again as dividend income for shareholders.

However, distribution of business profit as dividends is not required. The tax consequences are lower for the incorporated business when the shareholder does not personally need the profit. The corporation therefore retains profits after paying taxes at a rate that possibly lower than the personal tax rate.

A more likely tax savings is incurred from creating an S corporation. An S corporation also files a tax return but pays no income tax. Instead, shareholders of S corporations are taxed personally on their respective shares of business profit. Consequently, S corporation profit is taxed at personal tax rates. No self-employment tax is assessed on S corporation profit.

However, shareholders who are active in the business must receive reasonable compensation, upon which employment taxes are assessed. One-half of FICA taxes are deducted from paychecks—just as with any other employee. The company matches the other half of FICA taxes. So shareholders pay 100 percent of the FICA taxes by either payroll deduction or higher business expense.

S corporation shareholders save taxes when their reasonable compensation is less than the business profit. This leaves some corporation profit for distribution to a shareholder that’s separate from their wage compensation. There are no FICA taxes payable on the profit received by shareholders. Only wages are taxed under FICA.