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Small Business Reality Check: The Myth of ‘Double Taxation’

by Jason Dean 


taxesBeing financially smart today means more than simply living within your means, paying your bills on time, and setting money aside for retirement — it requires some foresight into the changing nature of the global economy. After all, the primary reason personal-finance education is so important today is that we can no longer count on big, paternalistic corporations to take care of us from cradle to grave. We each, individually, are responsible for our own long-term financial well being, and this fact has led many Americans to start their own businesses.

It’s a well known fact that most small businesses fail. But statistics citing a “failure rate” as high as 90% can be a little misleading. After all, if you start a business, run it successfully for four years, and then decide to move on to something new, was your business really a “failure”? And besides, innovations like eBay and Google AdWords have made running mini-businesses for supplemental income more practical (and lucrative) than ever. Just as the big businesses have gotten smaller, small businesses have become micro-businesses, meaning the financial commitment required to get them running has been reduced to nearly zero, and therefore, the risk of “failure” has been greatly diminished.

But this doesn’t mean that planning isn’t important. In fact, the more prepared you are with your business (i.e. writing a business plan), the greater the chances are for your ultimate success. But if you just want to start selling on eBay or build affiliate Web sites powered by AdWords, and you don’t plan on quitting your full-time job, then the worst thing you can suffer from is “analysis paralysis” — just get started and learn as you go: What do you have to lose?

In short order, however, you will want to make the decision to incorporate or use another”good” business entity such as an LLC or limited partnership. The “bad” entities include sole proprietorships and general partnerships. There are many resources outlining the benefits of incorporating, most especially the Rich Dad series of books, but for this article, we will just briefly explore the tax implications, which are often overlooked and/or misunderstood.

First, it’s important to note that when you incorporate, your business becomes legally distinct from you. It has its own equivalent of a Social Security Number (an EIN; Employer Identification Number) and it has to file its own separate tax return. The current IRS code taxes corporate profits at 15% for the first $50,000, and also charges a 15% (maximum rate, based on the recipient’s income) for dividends. In other words, if you wanted to take $50,000 out of your business, it would be taxed twice — once as profit, and a second time as a dividend. It is this double taxation that leads many people to avoid incorporating.

But this view leaves out the most important tax of all for most moderate-income people: FICA (Social Security and Medicare). Let’s say you earn $40,000 working a full-time job, and earn another $20,000 through your Internet business. If you weren’t incorporated (i.e. you ran your business as a sole proprietorship), the effective income tax rate on your $20,000 in business profits would be 24.7%. On top of this, you would pay 15.3% in FICA taxes — 7.65% as the employer, and 7.65% as the employee. Therefore, your total tax rate would be 40%!

By contrast, if your business profits were sheltered under a corporation, you would pay a tax rate of just 15%. This would leave you with $17,000 after taxes to pay yourself a dividend, which would be taxed at 15% for another $2,550 in taxes. This would total $5,550 in taxes, or an effective tax rate of just 27.7% — instead of the 40% a sole proprietor would pay.

What about FICA? It isn’t charged on corporate profits, nor dividends. So in this case, the “double taxation” of corporate profits and dividends is 12.3 percentage points less (over 30% less in “real terms”).

Of course, this all depends on your situation — if you earn more or less income at your job or with your business, your results may vary. But the main message is: Get informed! In this particular case, incorporation could have saved the business owner nearly $2,500 in a single year — and these kind of savings are what can help small businesses be in the 10% of companies that succeed.

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