I don't think that the average employee is aware that an entrepreneur/founder/self-employed person can save a lot of tax if they structure it right and are meticulous about it.
A self-employed person earning $70K a year can be better off than an employee earning $100K.
Small payroll income so that you fall within a low income tax bracket. Top up salary with dividends as they have a much lower rate of tax. If you have a live at home wife, make sure she's employed by the company in some form, eg. you can pay her the minimum wage for secretarial duties. Ideally falling within the tax-free lower bracket. Unlike regular employment, you can start claiming a lot of everyday things such as food/transport/home office electricity/internet/etc. as business expenses, thus meaning you can claim 20% VAT (sales taxes) back depending.
Ultimately, there's also the final payout if you manage to sell the company. If it were classed as regular bonus income, you'd be taxed at 45%. Instead you get charged as capital gains at 18-28%. You can also get entrepeneur relief on the first £10m which means you only get charged 10% instead of 28%.
NOTE: Some of these are loopholes like dividends and employing family. They tend to get cracked down on every now and again (I'm not even sure if they're valid now)
But when you get down to it, there are a heck of a lot of potential savings over standard income tax (currently 40% on anything over £32k, 45% over £150k)
I believe the using dividends for tax avoidance is either no longer effective or has been cracked down upon.
You can also give less to the government on your VAT if your profit (or revenues, I can't remember which!) is below 150,000 GBP. Rates vary between 9% and 15%.
So it's still worth it, but not quite as much as it used to be before IR35.
For consultants/freelancers/contractors - dividends can be fine, if you can mitigate your exposure to IR35 (typically a bigger issue for contractors). Groups such as the PCG can really help here, but really the key thing is ensuring that any contract can't be thought of as disguised employment (control, substitutability and mutuality of obligation being the keywords) - speak to a Lawyer or a specialist accountant for advice or other clued up contractors for advice.
The tax position on dividends is also a bit more subtle than above; if your total personal income is less than the £32k (minus allowances), then you're going to get the dividend tax credit back so the div is tax free. Granted the company is paying corp tax at 20% on all profits; but also it gives you options to defer company income becoming personal income, building up the company's reserves. As I understand it, you can wind up the company and get entrepreneurs relief which is also a worthwhile target for consultancies.
I'm assuming your work is legitimate self-employment, i.e., the people who pay you do not control your hours, tell you how or where to do your job, etc. If that's not the case, the law probably considers you an employee rather than an independent contractor[2], and you should be paid as one (W-2) - and you could get in trouble if you try to deduct expenses that are only valid for an independent contractor.
(I'm assuming you're self-employed, not incorporated.)
[1] http://employment.laws.com/self-employment
[2] http://blog.intuit.com/employees/1099-contractor-vs-w-2-empl...
It's somewhat of a pain getting this all going but once you do, you are operating as a corporation. Corporations do not pay income tax as such - they do have some filing fee type of taxes, but basically the taxes you pay come out of your payroll. So you do not pay tax on income that your company earns until you withdraw it from the company account via payroll. However, you can spend directly from the corporate account on anything that is reasonably considered a business expense. Computers and equipment, of course, can be purchased. Your company can pay the phone bills, internet connection, travel expenses, business lunches, etc. You can also charge your company rent as well if you are working out of your home.
What happens is that you wind up paying yourself a meager salary on which you pay normal tax just like everybody else. So for instance, your company earns $80. You pay yourself a salary of $15k and the remaining $65k money is spent on operating expenses and is a tax write-off. You only pay tax on that $15k. You're likely to even get a small tax refund check instead of a huge bill from the IRS. In some extreme cases you might pay yourself even less, or even come in at a loss and pay no income tax. There is nothing illegal about this as long as your write-offs can be legitimately considered a business expense.
This is also great because with payroll setup you are in a position to pay employees and sub-contractors via payroll as well and eventually grow your company with the proper financial system in place.
I would highly recommend having an accountant set this up for you and file your taxes though because it is a ton of work and requires understanding the ever-changing tax laws.
Are you sure that is correct? I am neither an accountant, nor even American, but IRS.gov says:
"The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation."
(source - http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employ...)
For the 2011 tax year, Wikipedia pegs the US federal income tax rate at between 15% and 35% (depending on income level).
(source - http://en.wikipedia.org/wiki/Corporate_tax_in_the_United_Sta...)
I think that only applies to C corporations, though I'm curious now about US tax law. Do tax shelters like you propose exist? Do you have any more information??
You get a choice: you can either have a pass-through entity (owners are taxed as if they received the income directly...even if they never actually receive it) or a deferral entity like a corporation (corporation is taxed, but its owner are not taxed until/unless they receive a dividend).
Moreover, even if you choose a pass-through entity like an S-Corp or LLC, the IRS places certain threshold requirements on the amount of income you must pay yourself, and on the self-employment taxes (FICA) you must pay.
Edit to add citation. Also, I'm assuming you're talking about an S-Corp, since it would make not sense for a C-Corp. From http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employ... :
"If most of the gross receipts and profits are associated with the shareholder's personal services [i.e. not from other employees or capital], then most of the profit distribution should be allocated as compensation."
If you're only paying yourself $15k of the %80k your company brings in, and that $80k comes from payment by clients for work that you personally did, then you are definitely on the wrong side of the tax code.
I can't help but notice that your quoted text says "most of the PROFIT distribution" rather than "most of the GROSS INCOME distribution" The company can't pay out more than it brought in.
Obviously if you don't have $65k in expenses then you can't claim them. But, working as a contractor can have a lot of expenses - travel, office rent, utilities, etc. Giant corporations claim these expenses, a single-person company is entitled to the same deductions.
In 15 years of business I have been audited twice by the IRS with very minor amounts due (< $500) and nothing to do with deductions or expenses. The reason I bring it up is simply to illustrate that I'm not just lucky or flying under the radar. One time it was my mistake of a missing payment in my records and I simply paid the amount due. The other time was the IRS's mistake and I successfully contested it. If I had anything to hide I sure as hell would not be contesting an IRS audit for some small amount of money. My point is that I am in no way hiding or trying to sneak around tax codes. I do not encourage anybody to do anything illegal. I only encourage anyone to claim the maximum amount of legitimate deductions that they're entitled to claim. I also highly recommend having an accountant handle it for you who knows the tax laws and ensures that you are operating within them.
In general the deductibility of expenses to the corporation is a huge advantage (of a C, S, or LLC), if you're a "professional" with a lot of expenses. OTOH, going from "dollar earned by C corp" to "salary paid by C corp, with both sides of the various withholdings, UI, etc." to "personal income" to "personal income with taxes paid" is MORE of a tax hit than just regular wage income. S/LLC give you the passthrough tax advantage but still have higher filing costs. It only really becomes worthwhile around $20-30k in side income for purely tax reasons.
There are plenty of non-tax advantages to incorporating, of course -- some level of asset/liability protection (most debts are firewalled at the corporation as long as you correctly treat corporate assets and liabilities as distinct from your own), the ability to take outside financing or do collaborations with other people, etc.
(I am not a lawyer; I am particularly not your lawyer.)
Normal corporations pay federal corporate income taxes directly -- and, as employers, they pay the employer share of federal payroll taxes as well.
It is true that there are kinds of corporations whose income is passed through to someone else and assessed against that person (notably S Corps, and T Corps in certain circumstances.)
I used to be an 'independent contractor'. I work for companies doing ecommerce / Java / Consulting work. I work a fixed term contract and leave when the project is complete.
I set up a limited liability company with me as the director and the only employee. When I get a contract (work), the client hires my company rather than hiring me directly. Depending on your specific tax laws, you pay a lot less tax using this kind of setup i.e. you pay yourself a low salary and the rest in (low tax) dividends.
This is the standard way most IT contractors operate.
(IANA Lawyer or Accountant)
So, say you live in a very relaxed tax environment, you can incorporate your LLC, sell software services to US companies and pay small taxes in your country.
References to:
- http://www.law.cornell.edu/uscode/text/26/861
- http://www.law.cornell.edu/cfr/text/26/1.1441-1
- http://www.irs.gov/pub/irs-pdf/i1042s.pdf
NAME_OF_COMPANY LLC is a single member LLC, and as such disregarded for federal tax purposes as a separate entity from its owner, FULLNAME, a resident of COUNTRY and a nonresident alien for US tax purposes. According to Section 1.1441-1 of Treasury Regulations (page 3 of the attachment) , payments made to a whole owned domestic entity that is disregarded for federal tax purposes and whose single owner is a foreign person, shall be treated as payments made to the owner of the entity. This means that payments made to NAME_OF_COMPANY LLC for federal tax purposes are considered to have been made to FULLNAME. The Regs go on to explain that the single owner of the US disregarded entity must furnish a From W-8 with his name and address to the US payor . An ITIN is required only to claim a reduced rate of withholding under treaty, but since in this case the payments were made for income from sources WITHOUT the United States, no withholding is required to begin with, so there is no need to claim any treaty benefits at all and provide an ITIN as a result.
If you want I can contact you with an specific accountant and you can discuss the details with her.
A noncitizen actually can use the USA as a tax haven in ways similar to this (I'm not sure of the specifics of this particular situation). IMO there isn't a whole lot special about non US people not owning US taxes when outside the US.
A US citizen or permanent resident is taxed on global income (you do get around your first 95k/yr deducted if you are out of the country enough, which is why I went diving for 4 months at the end of a contract and net made more money than returning to the US that year). A corporate entity being treated as disregarded just exposes that income the us person's global us tax liability.
(Again, I am absolutely not a lawyer; this is not tax advice)
N.B. I don't know why somebody downvoted me for clarifying the previous point.
In fact, what he's described works even better without the LLC, as the organizing an LLC in a state gives that state jurisdiction to tax sales to customers in that state! (State tax laws work differently than federal tax laws and are generally not affected by tax treaties.)