The proper business entity will save you tons on taxes.
Let’s start with why. Why would corporations and LLCs be good for small business taxes? It’s quite simple. If you don’t have any business structure whatsoever, then you are very likely operating a business illegally AND missing out on huge money saving opportunities. (We also have this brief video summarizing why they are important.) Let’s agree that you need some type of business structure, even if it’s the most basic entity.
I think of business entities sort of like a foundational tax saving strategy. When you have the right entity, more tax strategies become available and can build off the savings you’re already receiving. So, choosing the correct entity is one of, if not the, top strategy.
Entity refers to the legal structure of your business, like Sole Proprietor, LLC’s, S Corporation, etc. All entities are not created equal. Some are vastly different than others. Each type has its own advantages and disadvantages in how much it benefits your business and you personally as the business owner.
Disclaimer – we are not legal professionals. We have consulted with legal professionals about the legal side of the issues we’ll discuss, however, they are only suggestions and general advice that should NOT be taken for legal counsel. On the flip side, we are tax geniuses, so the tax stuff mentioned is based on years of experience from multiple professionals. But things change, so, a good policy would be to take the time to look into all of them and then consult with both a CPA (for the tax side) and a legal (for the… legal side) professional.
This isn’t a comprehensive list, but these are the top entities that you should know about because they affect small business taxes the most.
Sole Proprietor
From a tax standpoint, this is the WORST possible choice. First example of why it’s so terrible. A sole proprietor files business activity on Schedule C of the personal 1040 income tax return. This means all your business activity gets filed with the same IRS office that gets your personal info. This more than doubles your chance of getting audited. They like easy targets and it’s pretty easy to find discrepancies when both sets of info are right in front of them.
In most cases, the type of income a business owner makes is considered “ordinary” income. Ordinary income has the opportunity (as the IRS refers to it) to pay self-employment tax on the taxable income. This curse (as everyone else sees it) is a 15.3% tax. Being a sole proprietor, and not having the benefits of a more structured entity, there is no way around self-employment tax. So you end up having to pay that tax on top of what you’re already paying in federal and state income tax. You could be paying half your net income in taxes! The high combined tax rate is why this tax structure is the least useful for your business.
Another unfortunate note about sole proprietorship is you have basically no liability protection. Some other entities have what’s sometimes called a “corporate veil” that protects the owner from liabilities tied to the business. It’s like those entities can take a bullet for you. On the other hand, as a sole proprietor, you have nothing to stop a bullet. The business liabilities become your personal liabilities.
Single Member LLC
A single member LLC is among the most commonly used entity forms available to a business owner. They require essentially no corporate formalities to maintain, so the liability protection is there with little to no risk of messing things up personally for you.
From a tax standpoint a single member LLC is taxed EXACTLY like a sole proprietor. Not good. In fact, the IRS calls them “disregarded” entities which means they don’t exist in their minds. (Typical IRS.) That being said, you can make an election to tax your single member LLC as an S or a C Corporation (which the IRS can’t pretend doesn’t exist). Remember these are general guidelines. When used effectively, this entity can provide excellent savings for your small business taxes.
Single member LLCs are often required by lenders in sophisticated loan transactions because the lenders want what is commonly known as a “special purpose entity” to borrow the money. This is because, in part, such structures provide lenders with more certainty that they will recoup the debt obligations in the event of bankruptcy or litigation.
Multi Member LLC
The default tax setting for a multi-member LLC is the same as a partnership. It’s obviously similar in a lot of ways to a single member LLC, but just happens to be owned by two or more people. For example, it can elect to be taxed as an S or a C Corporation just like the single member LLC.
There are added benefits to this structure if managed properly. A multi member LLC is considered a “flow through” entity, which means they don’t pay income tax directly… usually. The taxable activity flows to each member based on his or her equity or other ratio defined in the governing documents, which is usually the operating agreement.
It’s important for tax purposes to define each member as ACTIVE or PASSIVE. If you are involved in the daily operations of the business, you are active. If you are not active based on that simplified explanation, then you are passive. For tax purposes, passive members have it best. (That doesn’t mean you can just call yourself passive because you want to. That’s not how it works.) The reason passive is better is because they don’t pay self-employment tax on their portion of the net income. Active members do.
A sound strategy we recommend is to have your spouse as another member of the business. They would play the role of investor, putting in seed capital and contributing cash as the business needs it. As is often the case, investors take a bigger portion because they are taking a higher risk with their money. The idea is to have your spouse, the passive member, own a much larger portion of the business, like say 80%, and then you, the active member, own the other 20%. Now you’re only subject to pay the self-employment tax on 20% of the net income. That’s a much better scenario with significantly more savings in taxes on the same amount of net income as a sole proprietor. (Plus, you’re not doubling your chances of being audited.)
In our experience, there’s generally not much at all involved in the formation or operation of an LLC. The members pay a small fee, provide a little info, and voila, you and your partners are ready to take on the world.
This seems like an appropriate time to advise you that the more partners who own a business together, the higher the chance of disagreements, feeling betrayed, being taken advantage of, or the business totally being torn apart and losing everything. This is a big reason why we DON’T recommend partnerships.
If you decide to enter into a partnership or multi member LLC anyways, it’s extremely important for all owners to communicate with each other and lay it all on the table in the beginning in a WRITTEN agreement. Set expectations, what are each of the owner’s roles, what do they do, declare ownership percentages, how will disagreements be resolved, negotiate the “out”, discuss standard operations, basically anything that could become a wedge between owners should be hashed out and agreed to… BEFORE starting the business. The important takeaway is to make sure there is a well thought out written agreement to govern the business relationship. No one regrets coming up with reasonable terms in the beginning. We strongly advise seeking competent legal counsel early on when contemplating the formation of a multi member LLC.
Series LLC
The series LLC has a reputation in the business world as that of a mythical beast that only the rich and famous are privy to. This entity has huge potential to limit liabilities and maximize tax benefits of numerous business assets without the cost and hassle of forming multiple entities along with the annual renewal and legal fees associated with them. While it should not be used in certain situations or to implement certain aggressive strategies, the series LLC does have its place and should not be shied away from.
The problem is the legal and tax situation of a series LLC is very unclear. Regardless of what regulations are proposed and therefore may or may not pass, we treat it just like any other LLC. You could be taxed as a partnership, single member LLC, or corporation depending on how you use it. For sure discuss this option with a professional.
S Corporation
Corporations are a little tricky compared to LLCs because depending on your jurisdiction, there may be formalities that must be followed by the shareholders and management team in order to maintain the entity protections. It’s important for shareholders to strictly abide by the corporate formalities required by the state in which it was formed. Those formalities often include filing of articles of incorporation, preparation of bylaws and organizational meeting minutes, and holding annual and sometimes special meetings. A shareholder agreement is not usually required but is advisable for reasons already discussed.
An S corporation is also a flow through entity but differs in that active members of a corporation DON’T pay self-employment tax on their portion of net income. The catch however is they are required to pay shareholder-employees (basically the same thing as an active member) a “reasonable wage”.
What constitutes a reasonable wage? Well… it seems the IRS doesn’t truly know because they haven’t defined what reasonable means. (How ridiculous is the IRS!)
Most guidelines professionals utilize come from court cases. Based on all the cases we’ve read, most people get themselves in trouble when they don’t claim any wages at all. You cannot say you were paid $0 for wages, and everything was a distribution. Obviously for tax reasons we want to keep the wage as low as possible, but zero is not an option. Because you’re paying yourself a w-2, you will have to pay payroll tax on those wages. That’s why we want to keep it small.
But how small is “reasonable”? Following are some of the guidelines that courts have considered.
- the individual taxpayer’s qualifications
- the nature, extent, and scope of the individual taxpayer’s work
- the size and complexities of the business
- a comparison between wages and the gross and net income of the business
- the prevailing general economic conditions
- a comparison of wages with distributions to other stockholders
- the prevailing rates of compensation for comparable positions in comparable businesses
- the wage policy of the business for all employees
- in the case of small businesses with a limited number of officers, the amount of compensation paid to the individual taxpayer in previous years
Regardless of how much you end up paying yourself in wages, it’s still less net income to pay taxes on than a sole proprietor.
C Corporation
Legally speaking, there’s little difference between S corporations and C corporations because the liability, organization, and maintenance aspects of the two are essentially identical. Taxes are where you notice the huge divide.
Significantly different from an S corporation, a C corporation is NOT a flow through entity. Shareholders are paid in dividends. And those have to be claimed on the owner’s personal tax return where they’ll pay capital gains on it. Those dividends are taxed at the corporate level first and then the shareholder also pays taxes on the same dividend on a personal level. This is known as “double taxation” and is the most common reason why C corporations are not recommended.
Each entity has a place… it just depends. The type of income you’re making, the industry you’re in, how many business partners you have, your exit strategy, and other factors will determine the best entity for you. (We believe the S corporation is generally the most beneficial entity for most small business taxes purposes.) Rest assured, whatever entity you decide on, a good accountant (or better yet, a Tax Genius) will find tax saving strategies you can use.
But if you want to make MONEY, enjoy PROFITS, and grow your WEALTH, then it’s well worth your time and effort to consult with a CPA and Lawyer.
The new year is approaching, but it’s not too late to benefit from quite a few tax strategies AND get a head start on next year.
Maximize your tax savings!
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