“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.