Tax Planning Benefits from Incorporating

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A corporation is a distinct legal entity that pays workers for their services. Corporate shareholders who operate the business are compensated just like any employees. This permits the corporation to provide employee benefit plans to the owner. An independent contractor taxed on income reported by Form 1099 is not entitled to establish employee benefit plans except for other workers.

In addition, no withholding of taxes is required from amounts paid to independent contractors. Instead, they are responsible for paying taxes on their income. Therefore, independent contractors normally pay quarterly estimated tax payments based upon their income expected on 1099s they will receive.

But a corporation withholds income tax for employees, including the operating shareholder. Tax paid with estimated payments must correspond with quarterly income to avoid IRS penalties. But tax paid by withholding is permitted at any time. The operating shareholder can pay bonuses at year-end that are entirely withheld for taxes in order to cover the entire annual tax liability.

Since a corporation pays wages to the operating shareholder, some reporting requirements exist. Payroll tax reports are submitted and payment of taxes is required after issuing paychecks. Payroll taxes include amounts withheld from paychecks plus those paid by the employer. In addition, an annual W-2 is provided for every employee.

A corporation is also responsible for payment of state and federal unemployment taxes. This includes a tax on wages paid to the operating shareholder. However, these taxes are normally much smaller than the tax savings from incorporating. Unlike unincorporated independent contractors receiving 1099s, the business profit of a corporation is not subject to Social Security and Medicare taxes.

Only the wages paid to the operating shareholder are subject to Social Security and Medicare taxes. In addition, the operating shareholder of a corporation can obtain personal benefits that are not paid as wages. For example, under a Health Reimbursement Arrangements (HRA) the corporation funds an account that pays for out-of-pocket medical expenses of employees—including the operating shareholder and immediate family members.

Contributions to an HRA are not included in the taxable income of employees. No federal income taxes or employment taxes are payable on HRA contributions. However, employees of an S corporation who are also shareholders do include contributions for their HRA accounts as taxable income. But the value of this benefit is only subject to regular income tax and is excluded from employment taxes such as Social Security and Medicare.