The next most expensive mistake is choosing the wrong business entity.
Most business owners start as sole proprietors, then, as they grow, establish a limited liability company or corporation to help protect them from business liability. But choosing the right business entity involves all sorts of tax considerations as well. And many business owners are operating with entities that may have been appropriate when they were established – but just don’t work as effectively now.
There are four ways you can organize your business:
- A proprietorship is a business you operate yourself, in your own name or trade name, with no partners or formal entity. You report income and expenses on your personal return and pay income and self-employment tax on your profits. These are generally best for startups and small businesses with no employees in industries with little legal liability.
- A partnership is an association of two or more partners. General partners run the business and remain liable for partnership debts. Limited partners invest capital, but don’t actively manage the business and aren’t liable for debts. The partnership files an informational return and passes income and expenses through to partners. General partner distributions are taxed as ordinary income and subject to self-employment tax; limited partnerships distributions are taxed as “passive” income.
- A C corporation is a separate legal “person” organized under state law. Your liability for business debts is generally limited to your investment in the corporation. The corporation files its own return, pays tax on profits, and chooses whether or not to pay dividends. Your salary is subject to income and employment tax; dividends are taxed at preferential rates. These are generally best for owners who need limited liability and want the broadest range of benefits. However, the administrative costs and complexities are also the highest.
- An S corporation is a corporation that elects not to pay tax itself. Instead, it files an informational return and passes income and losses through to shareholders according to their ownership. Your salary is subject to income tax and employment tax (Social Security and Medicare); pass-through profits are subject to ordinary income but not employment tax. These are generally best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations.
- Finally, a limited liability company (LLC) or limited liability partnership (LLP) is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLCs may offer the strongest asset protection of any entity. However, a limited liability company is not a distinct entity for tax purposes. Single-member LLCs are taxed as proprietors, unless you elect to be taxed as a corporation. Multi-member LLCs choose to be taxed as partnerships or corporations. This flexibility makes LLCs the entity of choice for many startup businesses.
I can’t make you an expert in business entities, not in a post like this. But I do want to walk through one popular choice to illustrate how important this question can be.
If you operate your business as a sole proprietorship, or a single-member LLC taxed as a sole proprietorship, you may pay as much in self-employment tax as you do in income tax. If that’s the case, you might consider setting up an S corporation to reduce that tax.
If you’re taxed as a sole proprietor, you’ll report your net income on Schedule C. You’ll pay tax at whatever your personal rate is. But you’ll also pay self-employment tax, of 15.3% on your first $127,200 of “net self-employment income” and 2.9% of anything above that. You’re also subject to a 0.9% Medicare surtax on anything above $200,000 if you’re single, $250,000 if you’re married filing jointly, or $125,000 if you’re married filing separately.
Let’s say your profit at the end of the year is $80,000.
You’ll pay regular tax at your regular rate, whatever that is.
You’ll also pay about $11,000 in self-employment tax.
That self-employment tax replaces the Social Security and Medicare tax that your employer would pay and withhold if you weren’t self-employed. If you’re like most readers, you’re not planning to retire on that Social Security. You’ll be delighted if it’s all still there, but you’re not actually counting on it in any meaningful way.
What if there was a way you could take part of that Social Security contribution and invest it yourself? Do you think you could earn more on your money yourself than you can with the Social Security Administration? Well, there is, and it’s called an S corporation.
An S corporation is a special corporation that’s taxed somewhat like a partnership. The corporation pays you a salary for the work you do. Then, if there’s any profit left over, it passes the profit through to your personal return, and you pay the tax on that income on your own return. So the S corporation splits your income into two parts, wages and pass-through distributions.
Here’s why the S corporation is so attractive.
You’ll pay the same 15.3% employment tax on your wages as you would on your self-employment income. (You’ll also pay the extra 0.9% Medicare tax on self-employment income exceeding $200,000 or $250,000, depending on whether you file alone or jointly.)
BUT – there’s no Social Security or self-employment tax due on the dividend pass-through. And that makes a world of difference.
Let’s say your S corporation earns the same $80,000 as your proprietorship. If you pay yourself $40,000 in wages, you’ll pay about $6,120 in Social Security.
But you’ll avoid employment tax on the income distribution.
And that saves you $5,184 in employment tax you would have paid without the S-corporation.
The best part here is that you just pay less tax. It’s not like buying equipment at the end of the year to get big depreciation deductions. That may be a great strategy, but it also means spending something on the equipment to get that depreciation. It’s not like contributing money to a retirement plan to get deductions. That may be another great strategy, but it also means you have to take money out of your budget to contribute to the plan.
Now, you still have to pay yourself a “reasonable compensation” for the service you provide as an employee – in other words, the salary you would have to pay to hire an employee to do the work for you. If you pay yourself nothing, or merely a token amount, the IRS can recharacterize up to all of your income as wage and hit you with some very hefty taxes, interest, and penalties. So don’t get greedy! But according to IRS data, the average S corporation pays out about 40% of its income in the form of salary and 60% in the form of distributions. So you can see that there’s at least a possibility for real savings.
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