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It can be advantageous for a relatively young business to organize as an S corporation. But once your company starts to show a healthy net profit, splitting off some business operations into a C corporation could lead to significant tax savings.
Why starting as an S corporation makes sense
To understand why this split can work in your favor, let’s first look at two key reasons an S corporation makes sense for many businesses early on:
- S corporations are what is known as “flow-through entities,” meaning the corporation itself doesn’t pay any income tax, and profits or losses flow over to shareholders to be claimed on their personal tax returns. This means that with an S corporation you are only taxed once, on your personal tax return, on the income your business makes. In a C corporation, your income can be taxed twice.
- When running an S corporation, a business owner avoids self-employment tax on net profit. That tax, which amounts to 15.3% of profits and is paid in addition to income tax, is levied on sole-proprietorships or general partnerships, and the tax bill can add up.
But this setup may present a problem once the business begins to do very well, because it leads to high personal taxes. If an S corporation has a net profit of more than $450,000, the highest personal tax bracket, it triggers a 39.6% tax.
Splitting the business: a hypothetical example
One way to deal with such a potentially high tax burden is to split off certain parts of your company (such as billing, human resources and employee benefits) into a new company. Under this setup, your S corporation would pay your newly formed C corporation for the services it’s providing your S corporation.
MINIMIZE YOUR S CORPORATION’S TAX BURDEN
Here’s an example of how it works: Let’s say in 2015 your S corporation is going to make a profit of $500,000. If you do nothing, you’d owe $198,000 in income taxes, based on the highest personal tax bracket. The smart thing to do is to split off some business operations into a newly formed C corporation, which pays tax at the federal and sometimes state level, with sliding corporate tax rates of 35%, 25% and 15%.
Before the end of the calendar year you could pay your new C corporation $300,000 for the services it’s performing for your S corporation. Your S corporation’s profit would therefore be lowered from $500,000 to $200,000, which would put it in the 28% tax bracket, meaning it would owe $56,000 in taxes instead of $198,000. This would save your S corporation $142,000 in taxes.
MINIMIZE YOUR C CORPORATION’S TAX BURDEN
Having minimized your S corporation tax burden, you can now go to work minimizing the tax burden on your C corporation. Because the fiscal year for the C corporation ends Sept. 30 in this example, you’d have nine months from the end of the previous calendar year to figure out what you want to do with the money in the C corporation.
You could use that cash for staff salaries and benefits with the goal of reducing profits and paying lower taxes, for example. You could also use a portion of the money to pay yourself a salary and start a retirement plan. Under some circumstances, owners can also start a fringe benefit program under a C corporation, which could include a company car, health insurance and a medical reimbursement plan.
Add up the savings
The goal of using a C corporation for salaries and benefits is to get the C corporation profit to under $50,000 so the business would pay 15% in corporate taxes, the lowest rate. In this example, that would mean paying less than $7,500 in C corporation taxes.
Added to the $56,000 in S corporation taxes, that means the business owner would pay a total of $63,500, instead of the original $198,000.
A final note
Before implementing such a strategy, consult a tax accountant to ensure you are correctly navigating the tricky rules of business taxes.
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