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I've often read opinions about taxation advantages of converting a personal business to a company but a point which confuses me is wouldn't the lower corporate tax rate be offset by the income tax when the company pays the "owner" shareholder?

Of course, this will change from nation to nation so for concreteness let's imagine this situation:

Let's see we have a individual consultant Mister Badger make an income of 100,000 USD per year. Imagine the corporate tax is 20% and personal income tax at that tax bracket is 30%. So effectively Mister Badger pays 30,000 as taxes and is left with a net income of 70,000 (to buy pizza and drink beer from)

Now if Mister Badger decides to incorporate, the new company Badger Consulting ends up getting the revenue stream of 100,000 and pays a tax of 20,000 on it. Which is great since its 10,000 less than the tax Mister Badger would have paid had he not formed a company.

But shouldn't the remaining 80,000 somehow move from Badger Consulting to Mister Badger? And at that point won't it get an income tax on it? Assuming it's still a 30% bracket, he pays another 24,000?

How is forming a company then a good idea from the taxation viewpoint? He ended up paying 20k+24k=44k versus the 30k he would have paid had he not incorporated.

I am assuming that the mode of transfer of 80,000 from Badger Consulting to Mister Badger would be as dividend? Is the dividend tax free from Income tax (say in the US)?

PS. I am implicitly assuming that the deductions for expenses would be same in both cases, approximately.

PS. Of course, there are other non-taxation advantages of incorporation. But let's stick to taxation.

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In the US, to reduce your tax rate, you can create an LLC taxed as an S-Corp. You can structure your compensation in two ways:

  1. Salary. This is taxed at the normal rate. The key thing is that you must pay yourself a "reasonable" salary. You can't underpay yourself.
  2. Dividends. This is taxed at a lower rate and reduces your overall tax burden.

There are a lot of online resources about how to do this, but this only works if your earnings are higher than a reasonable salary for what you do.

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  • So does this mean that the salary component gets taxed at the regular individual rate and the savings in rate are accrued on the dividend part? – curious_cat Jul 5 '20 at 13:16
  • @curious_cat, there are plenty of articles out there that will explain it much better than I can. My answer was to point you in the right direction. – gaefan Jul 6 '20 at 11:53
  • Ok thanks! Yes, the reference to "S-Corps" helped! – curious_cat Jul 6 '20 at 13:52

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