You can reduce overall income taxes by taking advantage of lower corporate tax rates.

The owners of a profitable small corporation can often save thousands of dollars in overall income taxes by keeping a modest amount of profits in the corporation and paying out the rest to themselves as employee salaries and bonuses. Called "income splitting," this works because corporate tax rates on the first $75,000 of corporate income are typically lower than the owners' personal income tax rates.

How Income Splitting Works

As you already know, a corporation is a separate legal entity from its owners, and it pays its own income taxes. This means that if the owners keep some income in the corporation (profits that are not paid out to the owners in the form of salaries and bonuses), it will be taxed at corporate income tax rates, not at the individual income tax rates of its owners. Income that is kept in the corporation is shown as "retained earnings" on a corporation's balance sheet, and is reported on IRS Form 1120 each year.

Federal corporate income tax rates on the first $75,000 of corporate income are often lower than the federal individual income tax rates on that same amount of personal income -- particularly if the person has additional income from other sources (see the chart below). This means that the corporation's owners might face a lower overall tax bill if they leave some income in the corporation as retained earnings. (These rates do not apply to professional corporations, which are taxed at a flat rate of 35%.)