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How Incorporating Can Result in Tax Savings
Medicare insurance tax of $35,900. If you were Ralph, would you pay $72,000 or $35,900?
It seems obvious that you should never declare dividends but should always take an additional salary or bonus out of your corporation, but that is not the case. If your total compensation is a couple of hundred thousand dollars, that should be no problem. But if you are successful and find the need to take a couple of million out of your corporation, and you do that all as salary, the IRS probably will disagree with your position that the lump sum payment was not a deductible salary, but really a disguised dividend, which is not deductible by the corporation. If that happens, that agency has the power to reclassify your salary as a dividend and subject you to the extra corporate tax involved, along with charges for penalties and interest. In other words, the IRS could wipe out that $2 million bonus.
It would seem that a possible solution to this bonus-versus-dividend dilemma is not to pay either but to leave most of the cash the corporation has earned in the corporate bank account. Of course, you would invest that cash so it would grow just as if it were in your hands. (This assumes you have already taken maximum advantage of tax-deferred accounts for your personal future.) Down the road, when you are ready to sell your corporation and retire, you hope you will be able to extract the cash from the sales transaction as capital gain, which is usually taxed at lower rates than ordinary income. Unfortunately, the IRS has a weapon with which it can force you to pay dividends. It is called the accumulated earnings tax and it works this way: If you leave more earnings in your corporation than you reasonably need for the future of the business, the IRS can levy and collect a tax on those excess earnings. The rate of that tax is the same as the rate of tax on dividend income to individuals.
INCORPORATE YOUR BUSINESS
How do you justify to the IRS that you do need to keep your accumulated earnings in the corporation rather than pay dividends? The IRS will accept the need for adequate working capital (what you have tied up in inventory and accounts receivable minus accounts payable); what you need for expansion of your business by internal growth or the acquisition of other companies, provided your business has a history of expansion; formal projections of future cash needs; and expansion plans that have been reduced to writing, such as in the corporate minutes (see Chapter 6). Before the IRS assesses a retained earnings tax on your corporation, you should engage a competent accountant to help you calculate working capital and expansion needs.
You can also use your corporate minutes to help justify paying salaries instead of dividends to stockholders/employees in more profitable years. In the corporate minutes, record the fact that the top executives (maybe it is only you) could command much higher salaries than they are currently receiving from your corporation, and that the shortfall is being recorded with the intention that it will be paid later in more profitable years. For instance, if you are taking a salary of $50,000 per year from your corporation, but as a CEO of a business like yours would command a salary of $400,000, there is a shortfall of $350,000 in your salary. Keep a permanent record of those annual shortfalls and pay them when your business is more profitable. The fact that you have maintained that record may justify unusually high salaries in later profitable years.
Pay Interest to Stockholders. You may have thought of this tax dodge already: Instead of issuing a lot of stock to yourself and other stockholders, simply issue one share of stock, for one dollar, to each stockholder and then supply your corporation with the operating cash it will need by
How Incorporating Can Result in Tax Savings
loaning the money to the corporation. Then you can pay yourself interest monthly and, as it is interest and not dividends, it will be a deductible expense for the corporation. Voila! You have avoided the double tax and have income from the corporation that is not subject to Social Security and Medicare taxes. Does it sound too good to be true? Of course it does. If you handle your corporation that way, the IRS will reclassify the loan as common stock and the interest as a disguised dividend. In other words, you will have accomplished nothing except to pay additional penalties to the IRS when they catch this gimmick two years after you have filed the corporationís income tax return. Could you possibly do something less drastic, such as fund the operating cash needs of the corporation one-half by sale of common stock to the stockholder(s) and the other half as a loan from the stockholder(s)? Something like that might be possible if you follow the IRS guidelines for the capital structure of a corporation. They are reprinted in Appendix A.
Alternative Minimum Tax on Corporations