Does incorporating shelter tax?
New business owners and entrepreneurs commonly wonder if the mere act of incorporating a business creates a tax shelter. People often wonder the same thing about limited liability companies, wondering if a limited liability company triggers any additional tax deductions or extra tax benefits.
Quick answer is "no"
The quick-and-dirty answer to these related questions are, "no." Neither you nor your business gets additional tax deductions or receives tax shelter benefits simply by incorporating or simply by forming a limited liability company.
An important bit of tax law to understand here is that a business may deduct any ordinary and necessary expense. And this rule works the same way for unincorporated businesses like sole proprietorships and partnerships as it works for incorporated businesses (including regular corporations and limited liability companies).
But every rule has exceptions
Not surprisingly, however, the usual rule that a business may deduct any ordinary and necessary expense, does get applied slightly differently to different sorts of entities. Accordingly, businesses and their owners may pay different amounts or types of tax with different types of entities. And I will summarize these pseudo-tax-shelter differences here:
Tax Shelters of Sole Proprietorships
A sole proprietorship isn't usually thought of as a tax shelter. But the sole proprietorship option does provide a couple of unique tax shelter opportunities. First, minor children of the proprietor can often be employed. Legitimate wages (if modest) won't be subject to any income or payroll taxes, though the wages may be deducted by the proprietor. This sole proprietorship tax shelter can easily save a couple of thousand dollars in tax for each minor employed. (If you're interested in how this works, see the ebook listed below this article.)
Another unique tax benefit available to sole proprietors is a healthcare reimbursement arrangement. If a proprietor employs his or her spouse, the proprietor can reimburse all of the spouse's family's healthcare expenses (including those of the proprietor!) and deduct these reimbursements as a business expense. This tax loophole not only saves income taxes but also saves self-employment taxes. Note, however, that a healthcare reimbursement arrangement isn't allowed under Affordable Care Act rules, as a practical matter, if the sole proprietorship employs anybody other than the spouse. Also, the reimbursement arrangement needs to be reasonable given the spouse's duties. You can't for example provide $20,000 of annual reimbursement for a two-hour a week job. (Note: We've got a longer discussion of this issue at our blog here.)
Tax Shelters of Regular "C" Corporations
A regular corporation, sometimes called a "C" corporation to distinguish the regular corporation from an S corporation, sort of provides some tax shelter benefits, too. Specifically, a "C" corporation can provide a rather rich set of tax free fringe benefits to employees including shareholder-employees. I discuss this point in another FAQ question-and-answer article, Which tax-free fringe benefits can a corporation provide to shareholder-employees?, so I won't go into the topic in more detail here.
Tax Shelters of S Corporations
As noted in numerous places at this website, an S corporation while not technically a tax shelter, does often allow its owners to avoid corporate income taxes. Furthermore, in many situations, an S corporation lets shareholder-employees pay lower levels of Social Security and Medicare payroll taxes. Again, I'm not going to go into more detail here about this "tax shelter" or "tax loophole" benefit. Instead, refer to the discussion, How much tax can an S corporation really save its owners?
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
Often the best tax saving tool private companies have? The Section 199A deduction which allows them to avoid taxes on the last 20 percent of their income.Read More
Using an S corporation for your business? To maximize savings, you need to minimize the salary paid to shareholders. But this decision is tricky.Read More
Nearly secret, the federal government's employee retention credits provide tremendous payroll tax savings for most small businesses... A new book from our firm explains.Info here