3 Ways to Get Tax-Free Income from Your Corporation

Photo: DNY59

No matter how profitable your corporation is, earnings are diminished by the taxes that have to be paid on the profits. Here are three perfectly legal ways to receive income on which no taxes are paid.


If your corporation has cash on hand, instead of distributing it to you as additional compensation, which is taxable, borrow it. A loan is not a taxable transaction, as is a sale, exchange, or bonus payment.

If the corporation charges you interest, then the cost of using the money is the amount of interest you must pay. However, as an owner of the corporation, you’re benefiting from the interest payment that the corporation receives.

If the corporation doesn’t charge any interest on the repayment, the company is deemed to receive the interest that should have been charged. The interest that should be charged is the IRS-set applicable federal rate (AFR) for the term of the loan at the time it is made. These rates, which change monthly, can be found at the IRS site.

Say you borrow $10,000 from your corporation on April 1, 2011, and promise to repay it, without interest, a year from now. The corporation must pick up interest at the AFR for a short-term loan made in April 2011 of 0.55%, or $55.

The corporation deducts as an offset to the “phantom interest” the same amount ($55) as compensation paid to you (even though you don’t receive a cash payment); you have to report the $55 as income. In the 25% tax bracket, the cost of this income is only $13.75 – not bad for being able to use $10,000 for a year.

What to do. Make sure that the loan is reflected in a promissory note and carried as a loan on the books of the business. If you fail to do this, the IRS can view the loan as taxable compensation because the lack of the loan formality suggests that the corporation did not expect to be repaid.

Fringe Benefits

As an employee of your corporation, you may be able to receive benefits paid by the corporation on which you aren’t taxed. This is a win-win for you and your corporation. You avoid income tax on the additional taxable compensation you would otherwise have had to receive in order to pay for the benefits yourself. And the corporation saves on payroll taxes it would otherwise owe if it had paid you taxable compensation instead of tax-free fringe benefits.

Here is a list of fringe benefits that owner-employees can receive tax free and which are exempt from both FICA and FUTA (federal unemployment) taxes. If you can receive them, then these benefits must be available to your staff as well on a nondiscriminatory basis.

  • Nominal (“de minimis”) benefits (e.g., cab rides home when working late);
  • Dependent care assistance (up to $5,000);
  • Employee discounts;
  • Group-term life insurance (up to $50,000 coverage);
  • Health savings account contributions;
  • Personal moving expenses (if your new workplace is at least 50 miles farther from your old home than your old workplace location was from your old home);
  • Retirement planning services;
  • Working condition benefits.

Find an explanation of these benefits as well as others in IRS Publication 15-B, Employer’s Guide to Fringe Benefits.

Note: Special rules apply to S corporation owners who receive health coverage from their corporations. The coverage is taxable to owners, who in turn can deduct the full amount on their personal tax return without having to itemize personal deductions.

Sale of Business Stock

If your corporation is a “qualified small business,” there is no tax on the gain from the sale of such stock issued before January 1, 2012, and held more than five years. The definition of a qualified small business is narrow, but worth exploring in view of the sizable tax break applied to it. The corporation must meet all of the following conditions:

  • It is a C corporation; S corporations do not qualify;
  • The corporation must be engaged in an active business;
  • The corporation is not engaged in personal service businesses such as engineering, architectural, accounting, and law firms; banks; financial service; mining; farming; and the operations of restaurants, motels and hotels. Technology firms, manufacturing companies, and retail establishments do qualify.

Stock must be newly issued for cash, property (other than stock), or services rendered to the corporation. Thus, a qualified small business can issue new stock to owners for services or cash. Owners need only hold the stock for more than five years to cash in on tax-free income.

More information on qualified small business stock can be found in IRS Publication 550, Investment Income and Expenses.

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