The BizFilings blog covering business tips and trends.
Why Are You Paying Employment Taxes on Your Investment Income?
Published on Apr 5, 2011
Read 'Why Are You Paying Employment Taxes on Your Investment Income?' at 'Time to Start Up,' the small business blog by BizFilings.
Being a small business owner requires the wearing of many hats. As the lead employee of the company, you must produce for today (creating products/services, managing employees, dealing with vendors and customers, etc.) and for tomorrow (strategic planning, raising capital, forging partnerships). And for all of these efforts, you receive monetary compensation.
But there is another role you serve for your business, separate of traditional employment: You are an investor. And part of the annual compensation you take home is tied to your investment in the company. Yet, many business owners still classify virtually all of their compensation as employment income, not investment income.
And for this oversight, those very business owners are penalizing themselves by paying higher taxes than required by law.
Lower your employment taxes.
As outlined in the article, “Operating as an S Corporation Can Lower Your Taxes,” you can legally split your take-home income among salary and dividends. By doing so, you shield the dividend payment portion from payroll taxes assessed on both the employee (you) and the employer (your company)—a more than 15 percent tax savings. Examples in the article illustrate this savings.
But it gets even better. . .
Dividends, for regular corporations, are not deductible expenses. So these dividends are considered corporate income subject to corporate taxes (as high as 35 percent), and then to individual dividend tax rates for the recipient. This is often referred to as “double taxation.”
But if you organize your business as an S corporation, these dividends are not exposed to double taxation, just the individual income tax. S corporations are considered pass-through entities for tax purposes, meaning that all earnings pass directly to the owners and are reported on their tax returns.
Form an S corporation, save money.
The key to this money-saving strategy is forming and electing S corporation status for your business.
To get started: You would need to form a regular corporation in the state of your choosing. Then you would need to elect S corporation status with the federal government, filing paperwork with the IRS to allow usage of simplified, pass-through taxation. Be sure to talk with your professional business advisor, lawyer or accountant when considering this options. You can also choose to use an incorporation services provider to help you with these business filings.
Liability protections save money, too.
Obviously, choosing an entity type for your business requires assessing many considerations. And taxation is certainly one of them—but it is only one. The unique circumstances of your business may dictate a different entity choice. If you plan to “go public” with your business, a regular corporation may be best; if you hope to pass along the company to your family members someday, maybe an LLC would be the choice.
There are no hard-and-fast rules about which form to choose. Some of it may rely on your particular comfort level and how you want to run your business. Just be sure to educate yourself on all of your options and to discuss them with a trusted advisor or professional.
And don’t forget: All three formal entity types mentioned above offer limited liability for its owners—your personal assets are protected from business debts. And these types of protections are hard to put a value on, especially when they are needed.
About the author
John L. Duoba is the publisher and managing editor of Business Owner’s Toolkit at www.toolkit.com, and while he is not a fan of double taxation, he has a soft spot for double-cheeseburgers.