From the Nolo eCommerce Center
You can reduce overall income taxes by using two different levels of taxation: yours and your corporation’s.
The owners of a profitable small corporation can often save thousands of dollars in overall income taxes by keeping a modest amount of profits in the corporation and paying out the rest to themselves as employee salaries and bonuses. Called “income splitting,” this works because corporate tax rates on the first $75,000 of corporate income are usually lower than the owners’ personal income tax rates.
How Income Splitting Works
As you already know, a corporation is a separate legal entity from its owners, and it pays it’s own income taxes. This means that if the owners keep some income in the corporation (profits that are not paid out to the owners in the form of salaries and bonuses), it will be taxed at corporate income tax rates, not at the individual income tax rates of its owners. Income that is kept in the corporation is shown as “retained earnings” on a corporation’s balance sheet, and is reported on IRS Form 1120 each year.
Because federal corporate income tax rates on the first $75,000 of corporate income are lower than the federal individual income tax rates on that same amount of personal income (see the chart below), corporate taxes on retained earnings can be lower. (These rates do not apply to professional corporations, which are taxed at a flat rate of 35%.)
Using Salaries to Control Income Splitting
You can use owner salaries and bonuses to control how much income is taxed at the corporate rate and how much is taxed at individual rates. Every dollar you pay yourself increases your personal taxable income and reduces the corporation’s taxable income – that is, the amount of business income taxed at corporate tax rates. (This works because the corporation can deduct 100% of salaries and bonuses.)
On the flip side, if you lower your salary and bonuses and leave this money in the corporation, your personal taxable income will decrease, and the corporation’s taxable income will rise.
Using salaries in this way allows for great flexibility when you’re searching for ways to save tax dollars.
Practical Management of Profits
Reducing taxes is just one of several things you should consider when deciding how to split your corporation’s income. Many other practical and economic needs determine the amount of money that should stay in a corporation – owners need salaries on which they can live comfortably and the corporation needs money to cover its expenses. In addition, the IRS places limits on the amount of money your corporation can retain.
Especially in the early days of a business, owners typically find that they must retain some profits in the corporation to buy inventory and equipment, meet payroll costs, develop new products and cover other expenses of a growing business. Fortunately, up to $75,000 of these profits will be taxed at the lower corporate tax rates.
As a business matures and begins earning more than it needs to fund growth, the owners will no doubt want to pay out more corporate profits to themselves in the form of salaries and bonuses. Regardless of the possible continued savings from income splitting, owners are likely to increase their salaries or declare bonuses if the corporation’s cash reserves are adequate to meet foreseeable needs. Plus, the possibility of savings from income splitting decreases as more profits are kept in the corporation – rarely will a corporation save money by retaining more than $100,000 of profits in the corporation each year.
IRS Limits on “Accumulated Earnings”
The IRS may limit the amount of money your corporation can retain. Usually, you can keep a total of $250,000 of “accumulated earnings” in the business at any one time, no questions asked (for professional corporations, this amount is limited to $150,000).
You can retain more earnings if you have a valid business reason, but if the IRS decides you are simply trying to lower your taxes by keeping profits in the corporation, you can be hit with a penalty tax that equals the highest individual tax rate (38.6% in 2002). This penalty can easily wipe out any benefit you received by keeping excess money in the corporation.