Are you a sole proprietor or member of a partnership? You probably realized that you now send a ton of money directly to the government.
You didn’t start your business for the joy of giving away your hard-won earnings only to pay more tax than you did as a W-2 employee.
If your growing business is also growing its tax bill, then you have options. Incorporating yourself may not have made sense on day one, but it might now, particularly as your personal assets also grow.
If you’re ready to grow into a new business structure and save money on taxes, then you need to know about the tax advantages of incorporation.
1. You Get More Deductions
Corporations enjoy more tax deductions than sole proprietors. Even though the new Tax Cuts and Jobs Act (TCJA) got rid of some of the more creative deductions, plenty remain.
These deductions include some of your biggest bills, including medical insurance for your family.
For example, if your business is a corporation, you can deduct 100 percent of the insurance premiums paid by your company rather than a portion. You also get extra help with education costs and other expenses.
2. You Skip Self-Employment Tax on Your Total income
Your first year of self-employment likely came with sticker shock. Self-employment tax is higher than the tax you paid as a W-2 employee.
When you’re a sole proprietor (or are unincorporated), you pay Social Security taxes on every dollar you bring in, which can amount to 15.3 percent of all your income.
If you incorporate and pay yourself a salary, then you only pay Social Security taxes on your salary – and the rate is lower. The rest of the money you earn that remains in the business doesn’t contribute to Social Security.
3. You Can Spread Your Losses
Everyone can deduct their losses, whether you are incorporated or not.
If your small business runs a loss for the first few years, you subtract the loss from your tax bill. You can also carry the losses forward for up to seven years, to continue paying lower taxes and make up for the first few difficult years.
4. You Can Keep Profits in the Business (and Get Extra Advantages)
When you are a partner or sole proprietor, all money that comes in is taxable.
For high-income earners, there are real disadvantages to a sole proprietorship because you must pay taxes on your entire income each year.
If you have a corporation, you can leave the money – bar your salary – in the business. When you do this, you avoid the higher individual marginal tax rate. You can then take the money out when your tax rate is lower, such as in years when your income is lower.
Taking this route can save you tens of thousands of dollars once you begin earning in the mid-to-upper six figures.
You still have the money – and you always pay tax – but you determine when and how you get paid.
5. You Can Split Your Income
Incorporating means taking on shareholders. But your shareholders aren’t limited to yourself or your partners. You can also nominate shareholders in your corporation and pay them dividends.
An S Corp allows you to have up to 100 shareholders who can receive your net profits in the form of dividends.
You can give yourself and your employees a salary (or wages). And then, you can make tax-free non-dividend distributions according to the shareholder’s stock basis. However, when those distributions reflect a payment higher than the shareholder’s ownership, they become capital gains, which are taxed.
For example, you can nominate your children to be shareholders and redistribute income to your children, who are very likely to be in a lower tax bracket than you.
What Corporate Entity Offers the Most Advantages?
As an S Corp, you are a pass-through business, which means you don’t need to pay taxes on any corporate income. The profits, losses, and deductions flow through you – the owner – and your shareholders instead. You then pay your income only on your tax returns.
For most of those who start as sole proprietors or partnerships, S Corps make the most sense at the start. An S Corp can hold up to 100 shareholders, which is perfect for a small to medium-size business.
The next level up is a C corp. C corporations are for companies who have plans to go public. The tax difference is that a C corp gets taxed separately on its profits, and then the shareholders also pay tax when they receive their dividends.
Things to Think About Before You Incorporate
The tax advantages of incorporating yourself are significant. They provide flexibility, savings, and a chance to control the way you earn over the long-term.
However, it is impossible to deny that incorporating a business also makes the business structure more complicated. In addition to the advantages of incorporation, you also need to think about:
- More (and complicated) paperwork
- Filing another tax return
- Giving up personal tax credits
- The expense of incorporation (initial fees plus legal and accounting costs)
Before deciding whether or not and how to incorporate, talk to both a business attorney and your CPA. They can point you in the right direction and provide you with a clear picture of what to expect from incorporation.
The Advantages of Incorporation Means Saving Money
The tax advantages of incorporation can save you tens of thousands of dollars a year in taxes. Thanks to a long list of deductions and more flexibility in withdrawing your money, you can use an S Corp or C Corp to build the financial future you deserve.
Are you considering incorporating to protect your assets and reduce your tax bill?
We can help. Get a free 15-minute consultation with an incorporation specialist to learn what entity is best for you.