Reposted from 02/23/2017
Creating a corporation can be a great form of asset protection – but did you know that a corporation can be a tax shelter as well? A tax shelter is a legal way to decrease or minimize taxable income, which reduces your overall tax liability.
The simple act of incorporating does not automatically grant you a tax shelter. Instead, the real advantage is the expenses you can deduct as a business expense that would not be deductible personally. Businesses are only taxed on their profits, not on their gross revenue. In other words, they are taxed on every dollar they earn, less their legitimate expenses. This is completely unlike individual tax returns, which are taxed on their gross income, less a few deductions which may or may not apply to you.
In very simple terms, individuals earn money, pay their taxes on that income, then spend whatever is left. Businesses, on the other hand, earn money, spend what they need, and only pay taxes on their profits!
Of course, incorporating just to avoid taxes is illegal. You must have a legitimate business reason and a profit motive to incorporate. If you have a sole proprietorship, incorporating can help with asset protection and may save you money at tax time.
Timing Is Important
If you have been considering starting a new business, 2017 may be the perfect time to pull the trigger. As a general rule, you cannot recharacterize expenses once they have already been incurred. That means that if you start a business, you should also incorporate in the same year to capture the tax savings of some of those costs. Failure to “capture” these costs could mean that you miss out on significant cost savings.
Consider an example. Many people ultimately turn their hobbies into side businesses or full-time businesses. Mary buys a spinning wheel in January 2017 because she enjoys making her own yarn and using it to create sweaters, scarves, baby clothing, blankets, and a variety of other goods. She recently learned that there is a demand for home-spun wool, so she has been selling it to neighbors and friends for a few months. Mary also sells some of the products she creates with her wool. She created an online shop in August, and now her little side business is beginning to turn quite a profit. Mary must report this extra income to the IRS and will be taxed on it as if it were her income from her regular nine to five job.
She could reduce her taxes if she can expense the supplies that she has purchased, including the spinning wheel (which was pricey). However, she must list this “startup” cost as an expense in 2017 or she will forever lose it. A good way to do that is to be sure that she incorporates during 2017 and tracks all her startup-related expenses – even though she incurred those costs long before she considered herself an actual business or started making any money. She can also expense costs related to going through the incorporation process as well.
Unique Small Business Tax Deductions
Small businesses can also make tax deductions that individuals simply cannot. Education is a prime example. If your education is required by your existing employer or if it helps you advance your skills in your current profession, you may be able to deduct tuition and related costs as a business expense. Education costs can include much more than the traditional “going to college.” It can also include things like seminars, trade shows, and continuing education. Magazines, CDs, DVDs, or books that you purchase related to your business or industry may also be a great deduction. It pays to learn and get better at your craft from both a business and a tax standpoint.
Travel expenses are another good business deduction. If you have to travel to attend conferences or shows, or visit clients, your business travel expense can be entirely deductible. This includes direct costs like hotels, flights, gas, cabs, and other necessary on-the-road expenses. You can deduct up to 50 percent of your food on the road as well.
If your small business has employees, they can be a good source for deductions as well. Many smaller companies choose not to use employees because of some of the complex employment laws and related tax requirements, but if your business is growing, it may be worth considering. The following employee-related expenses can be deductible business expenses:
- Employee salaries or wages
- Employee benefits (health plans, life insurance, educational assistance, and other benefits)
- Profit-sharing or pension plans
- Office-related expenses for desks, supplies, computers, and other related expenses
Running your own retirement savings through the company can also help you decrease taxes overall as well.
The Type of Corporation Matters
“C” Corporations have their own tax rules; it is taxed as a separate entity entirely. As such, there are certain deductions only available to C-Corporations. The company pays taxes on the profits while its shareholders do not. Instead, the shareholders are taxed on the income that the C Corporation provides to them. While the potential is there for double taxation (first at the corporate level, then again at the personal level), this can usually be avoided in small businesses by having the managers and directors (generally the business owners) expense out all the profits of the company through either perks or salaries.
The “S” Corporation does not pay any income taxes on its own. Instead, it is a “pass-through” entity. That means that the individual shareholders will include their share of the company’s profits on their own tax returns. They will then pay taxes on the profits based on their individual tax rate.
While both types of corporations offer tax advantages and corporate veil protection for the owners, an S Corporation is often viewed as the better “deal” for start-up companies. Many new businesses may lose money in their first few years of operation, and an S Corporation allows those losses to “pass-through” to the owner’s individual tax returns, thus reducing their taxable incomes. S Corps may also enable owners to pay less in Medicare and Social Security taxes as well.
Getting Ready for the New Year
The new year is a great time to consider incorporating so you can take full advantage of asset protection benefits and decreased tax liabilities for the entire year. Learn more tips and tricks by making use of our resources at Protect Wealth Academy. Sign up for a free membership today.