"Anyone may so arrange his affairs so that his taxes shall
be as low as possible. He is not bound to choose that pattern
which best pays the treasury. There is not even a patriotic
duty to increase one's taxes." --- Learned Hand
You know that old riddle. "Which came first, the chicken or the
egg?" I have my own version of the riddle. "Which comes first?
Taxes or expenses?"
Unlike the chicken or egg conundrum, this riddle has a clear
answer. And the answer is, "It depends on whether you are paying
taxes as an individual or as a corporation."
We hear a lot of talk these days about the inherent unfairness of
the tax system. The claim is that "the rich" get tax breaks
while middle and lower class taxpayers pay far more than their
fair share.
What gets lost in these comments is an even more fundamental
imbalance in the tax system. The tax system favors corporations
vastly more than it favors individuals.
The crucial difference between corporate taxes and personal taxes
is the point at which taxes are calculated. If you are taxed as
an individual, your taxes come off the top of your income. If
you are taxed as a corporation, your taxes are calculated after
expenses.
"You don't pay taxes - they take taxes." --- Chris Rock
Consider how the taxation system works. If you are an employee,
you collect a paycheck. Before you ever get your paycheck,
there will be deductions. Federal tax, FICA, maybe state tax,
maybe medical insurance. You will be left with your "take home
pay." Interesting concept, isn't it? What you "take home" will
be less than what you earned.
In other words, you get to use whatever is left over of your
salary or wages after taxes. Food, housing, clothing,
transportation, medical, dental, recreation. You need to pay
for all of these expenses with your "after tax" money.
"Our new Constitution is now established, and has an
appearance that promises permanency; but in this world
nothing can be said to be certain, except death and taxes."
--- Benjamin Franklin
As one example, let's consider medical costs. Who pays your
medical expenses if you are an employee? Medical insurance in
the United States is an unwieldy and expensive mess. Maybe you
are covered by your employer, maybe not. What we do know is
that medical costs are rising exponentially, and most striking
unions cite increasing medical costs to employees as their
primary grievance. Even if you have medical insurance, you will
have to pay deductibles. And you will pay these expenses with
after tax dollars.
And when you finally come to calculate your taxes on your 1040
form, you will find that you cannot claim medical costs as
deductions on your tax return unless medical expenses exceed 3%
of your income.
"The avoidance of taxes is the only intellectual pursuit
that still carries any reward." --- John Maynard Keynes
What happens if you set up a corporation? You are the founder
of a corporation and hire yourself as the employee of the
corporation. As the founder of the corporation, you are able to
set up a health insurance plan with pretax dollars. If there
are insurance deductibles, you, as the founder, can write a
resolution and put it in your corporate book. Your generous
corporation will cover all of the costs of medical care for its
employees (that means you,) including deductibles, and any
medical costs that most insurance policies will not cover.
After all, as the founder of the corporation, you are free to set
up any medical reimbursement plan you wish, as long as you put it
in writing in your corporate resolutions. And before you figure
out how much tax the corporation owes, you first calculate all of
the medical expenses paid by your corporation and then calculate
the tax after expenses.
That means, instead of filling out a 1040 form for personal
taxes, with your non-deductible medical expenses, you file an
1120 corporate form. If you are an employee of your own
corporation, your corporation can pay for your medical insurance.
And if there are deductibles, your corporation can file a
resolution to cover all uninsured medical costs. Do you grasp
how significant this distinction is for your economic well-being?
This distinction is particularly meaningful for me. I have a
chronic health condition that my former medical insurance company
considers "high risk." The insurance company agreed to continue
to insure me, but at a cost that was exorbitantly high, and would
have come out of my personal after-tax income. For me, this was
not only a matter of money. It was a matter of being able to get
any kind of medical insurance. Many people with chronic health
problems become "uninsurable" at any price.
However, since I am the CEO of the corporation I founded, I was
able to set up a health insurance program through the
corporation, at a significantly lower rate than the one offered
by my prior insurance company. The corporation now pays the
health insurance premiums with pre-tax dollars. And as the
founder of the corporation, I have written a resolution that the
corporation will pay any deductible costs, and any other costs
related to my medical care. Only after all of my medical costs
are paid, the corporation will calculate the taxes it owes.
I could give other examples. Your corporation can provide
generous pensions, annuities, life insurance policies, and other
benefits to you as an employee. It can even donate generously to
nonprofit corporations, schools, and churches, if it chooses.
And after it has paid all of these expenses, and made all of
these charitable donations, it can then calculate tax on the wee
bit of profit left over. Or maybe the corporation will not have
any profit at all, and then it will not pay taxes at all.
I feel compelled to point out that it has not always been this
way. Corporate America used to pay a much higher portion of
taxes than it pays now. This is the real unfairness of the tax
system. The discrepancy between tax rules for corporations and
tax rules for individuals means that the tax burden has shifted
from corporations to individuals.
"We don't pay taxes. Only the little people pay taxes."
--- Leona Helmsley
Why are "the rich" getting richer? At the heart of the matter,
"the rich" understand the tax system and know how to set up
corporate entities to make the most of the favorable tax laws
available.
Is it fair? Is it just? Can you or I change the system? For
myself, this is a bigger challenge than I am willing undertake.
It is the way it is.
Unless you want to play David against Goliath, or Don Quixote
tilting at windmills, you would do well to understand the
inherent imbalance in the system, so that you can use the system
for your own benefit. This means that the fastest route to
keeping more of your own money and creating wealth is to set up a
corporation and pay taxes as a corporation rather than an
individual.
"You know, gentlemen, that I do not owe any personal income
tax. But nevertheless, I send a small check, now and then,
to the Internal Revenue Service out of the kindness of my
heart." --- David Rockefeller
My point is that setting up a corporation allows you to use your
income to provide benefits you cannot afford with your after-tax
dollars. The corporate tax code allows you to create wealth in
ways that you will never be able to accomplish as long as your
taxes come off the top of your income. In addition, corporate
tax rates are lower than personal tax rates.
If you have not set up a corporation, I encourage you to consider
doing so. People are afraid that incorporating means a lot of
extra work and trouble. Yes, incorporating involves time, effort,
and expense. And keeping your corporate records up to date also
takes time, effort, and expense. You will also need to have
increased knowledge of taxes and accounting. The reward for
this extra work and effort is that you will be able to use
corporate tax rules for your own benefit, and the benefit of
those you choose to support with your money.
"We contend that for a nation to try to tax itself into
prosperity is like a man standing in a bucket and trying
to lift himself up by the handle." --- Winston Churchill
To answer my own riddle, "Which comes first? Taxes or
expenses?" If you are paying taxes as an individual, the taxes
come first. If you are paying as a corporation, the expenses
come first.
This difference is enormous. When you understand this
distinction, you have one of the most powerful means to transform
your economic life from struggle to abundance.
Knowing how to use the corporate tax code legally and ethically
will allow you to create an abundant life far beyond anything you
will be able to create with the personal tax code.
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