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%.)

Using Salaries to Control Income Splitting

You can use owner salaries and bonuses to control how much income is taxed at the corporate rate and how much is taxed at individual rates. Every dollar you pay yourself increases your personal taxable income and reduces the corporation's taxable income -- that is, the amount of business income taxed at corporate tax rates. (Because the corporation can deduct 100% of salaries and bonuses, every dollar you pay yourself is a dollar on which the corporation won't have to pay tax.)

On the flip side, if you lower your salary and bonuses and leave this money in the corporation, your personal taxable income will decrease, and the corporation's taxable income will rise.

Using salaries in this way allows for great flexibility when you're searching for ways to save tax dollars.

Practical Management of Earnings

Reducing taxes is just one of several things you should consider when deciding how to split your corporation's income. Many other practical and economic needs determine the amount of money that should stay in a corporation. Owners need salaries on which they can live comfortably, and the corporation needs money to cover its expenses. In addition, the IRS places limits on the amount of money your corporation can retain. Here are some of the non-tax reasons you may need to retain or pay out earnings in a corporation.