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Small business owners usually minimize their taxes by operating as a sole proprietorship, partnership or S corporation. Or by operating as a limited liability company taxed as a sole proprietorship, partnership or S corporation.
However, even though C corporations may cause a business to pay a second level of tax on business profit, a C corporation may save the small business owner taxes in at least three situations.
C Corporations Allow for Richer Fringe Benefits to Owners
With sole proprietorships, partnerships and S corporations, the tax-free fringe benefits available to owners are very limited. Sole proprietors, S corporation shareholder-employees, and partners may typically deduct health insurance and pension contributions. But not much else.
In comparison, a C corporation can typically provide the same tax-free fringe benefits to owners as it provides to rank-and-file employees. These additional tax-free benefits might include tax-free housing, educational assistance, life insurance--and several other items as well.
A C corporation may also allow a business to provide better healthcare benefits for shareholder-employees. In other words, though this isn't true for sole proprietorships, partnerships and S corporations, a C corporation may be able to discriminate in favor of corporate officers or shareholder-employees and provide them with better or more healthcare benefits.
C Corporations May Minimize Income Taxes on Reinvested Profits
All of the profit of a sole proprietorship, partnership or S corporation gets allocated to the business owner or owners and then taxed on their personal income tax returns. This means, in effect, that the last dollars of profit the business makes--money it's probably reinvesting in its business--get taxed at the owners' highest marginal tax rate.
And that rate can be crushing. The top marginal tax rate on a small business owner can easily be forty or fifty percent when you combine federal and state income taxes and any self-employment taxes. A sole proprietorship, S corporation or partnership may pay as much as $20,000 in income taxes if it reinvests $50,000 of profit in the business.
Modest amounts of C corporation profit, however, get taxed at modest rates. For example, the first $50,000 of a C corporation's profit is typically taxed at rates of 15% to 20%. A C corporation reinvesting $50,000 in its operation may pay more like $10,000 in tax on the reinvested profit.
C Corporations May Reduce Out-of-State Taxes A business that operates in multiple states typically pays taxes not just to its own home but also to the other states where it employs people, holds property or provides services or sells products.
Without going into tedious detail, businesses pay taxes to all of the states in which they operate because tax laws require businesses to apportion their business profits among the states of operation.
As a practical matter, though, many small C corporations extract most of all of their business profit in the form of salaries and tax-free fringe benefits. That means a small C corporation typically has less, "left-over" business profit. And less business profit means less state income tax.
Seattle tax accountant Steve Nelson specializes in small business taxation. The author of Quicken for Dummies, he also edits the do it yourself incorporation and llc formation web sites.
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