The Tax Advantages to Investing in a Small Business

by Leslie McClintock

Congress provides a number of tax advantages to those who invest capital into a small business. The intent is to encourage those with money to invest to put their capital to work to create jobs, generate wealth and produce tax revenue to fund government operations and programs. Business owners have more options for tax credits and deductions than those living by working regular jobs, and have more control over timing the receipt of income.

Dividend Income

If you invest money in a corporation, and that corporation provides income to you as the owner in the form of dividends, that dividend income is taxed at a much lower rate than ordinary income. Dividends from qualified U.S. corporations have a maximum tax rate of 15 percent, compared to a maximum of 35 percent for ordinary income, as of the time of publication. Dividends are also exempt from self employment tax -- which saves another 13.2 percent, as of the time of publication.

Capital Gain Tax Rates

When you invest money in assets and later sell them at a profit, the IRS generally charges you capital gains tax on the profits. This is roughly the price you receive for the asset, minus the total amount of capital you have invested in it over the years for which you did not take a tax deduction. As of the time of publication, the top tax rate for long-term capital gains was 15 percent, and was lower than ordinary income tax for every tax bracket. Short term capital gains (held for less than one year) are taxed at your regular tax rate.

More Deductions

If you don't own a business, you are limited to either taking the standard deduction or itemizing deductions on some personal expenditures, such as home mortgage interest and medical expenses. You can only deduct miscellaneous itemized deductions to the extent they exceed 2 percent of your income, and for medical expenses, the threshold is 7.5 percent. This can mean you will have to pay taxes on hundreds or thousands of dollars in income before you can benefit from itemizing. Business owners and shareholders can deduct many expenses as business expenses, using Schedule C, Profit or Loss From Business, rather than Schedule A, Miscellaneous Itemized Deductions.

More Retirement Advantages

Most workers are limited to individual retirement arrangements (IRAs) and whatever their employer allows them to contribute to a 401(k) or 403(b), if the employer has a pension plan at all. The small business owner, however, can deduct up to $49,000 per year, or 25 percent of income (minus self-employment tax), whichever is less, into a simplified employee pension plan he designs specifically for his needs. Special rules apply to self-employed individuals, because they also pay self-employment taxes. See IRS Publication 560 for details on how to figure the allowable contribution for small business owners. The small business owner can also deduct the cost of providing medical insurance to himself and his whole family, and he can design a plan to fit his own needs and budget.

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