If your New Year’s resolution is minimizing business expenses, look no further than the cost of taxes. Visualizing the tax savings available for an incorporated business begins with an examination of the tax costs from not incorporating. In fact, the tax burden on an unincorporated independent contractor is significant.
As a self-employed independent contractor, your personal taxable income consists of amounts paid to you that are usually reported on Form 1099. Some independent contractors are paid by only one or two businesses. Ordinary and necessary expenses are subtracted from the amount on a 1099 to determine profit from your business activity.
Income tax is calculated by adding the profit as an independent contractor to all other sources of income on your personal tax return. In addition to the income tax impact of your independent contractor profit, this business income is also subject to self-employment tax. That’s the tax covering Social Security and Medicare assessment on self-employed individuals.
Wage earners have Social Security and Medicare taxes deducted from their paychecks under FICA. In addition, their employers match the other half of these taxes when remitting them to the US Treasury. A reduction in this tax is the savings you realize from incorporating.
Only workers pay FICA taxes. This includes payment of these taxes by self-employed workers. But individuals who are simply owners of a business do not pay taxes under FICA. For example, any outside investor in your business does not pay self-employment tax on his share of the profits—as long as he isn’t active in the operation.
The same principle applies to shareholders of a corporation. They don’t pay FICA taxes on their share of profits. FICA taxes are only assessed on their wages. A business owner who incorporates therefore experiences savings on these employment taxes.
FICA taxes are assessed only on the business owner’s compensation as an employee of the corporation. The profit of the corporation is distributable to the business owner without incurring FICA taxes. This is unlike the self-employed independent contractor, who pays the self-employment tax (comprising taxes under FICA) on all of his business profit.