How Your Business Influences Your Taxes

When you set up your business entity – sole proprietorship, partnership, corporation, or Limited Liability Company – there are tax differences between each one. Today, we are discussing how each business entity influences your taxes.

Sole Proprietorships

This is the easiest and quickest business entity. When you operate under this entity, you only need a Schedule C and a Schedule SE when you file your taxes.

Corporation

You have the option of going with a C corporation or an S corporation when you want to operate under this entity. With a C corporation, you will have to have a Form 1120 or Form 1120 A. When you go with an S corporation, you are limited to 100 shareholders and you must file Form 1120S and report your share of the income on Schedule K-1. Additionally, if the taxable income is $50,000 you will be taxed at a 15% rate and the maximum rate you can be taxed at is 35%.

Partnerships

Partnerships do not pay taxes since they are only reporting entities. However, the partners have to report their income and expenses on Form 1065.

Limited Liability Companies

These are the newest form of business entities. They are not able to offer tax-free fringe benefit packages to their corporate employees though. They are said to be the entity of the future at this time, but they have some issues that need to be resolved.

Closing Thoughts

Overall, you have to make sure that when you choose your business entity that it is the best for your business. However, at the same time you want to keep in mind the tax consequences.

Remember we have clients in Redmond and can be a Redmond CPA firm for small businesses!

Entity Selection (LLCs and S Corporations)

Small Business Webcast is a great place for people to come for free continuing education on several elements important to small business. Its mission is to promote the health and wealth of small business. One of the excellent resources the site has to offer is its recorded webcasts on a variety of helpful topics.

Check out the webcast on reducing taxes through entity selection, LLCs & S Corps Explained – Using them to Reduce Taxes, or read the transcript below if you prefer. Also, don’t forget to visit our Self-employed Tax Guide, which can be used as an excellent tax resource for people who are their own boss. Just a couple of the beneficial articles available:

LLCs and S Corps Explained – Using them to Reduce Taxes – Transcript:

This presentation will be on entity selection, and in particular the tax advantage of whatever type of entity you want to use for your business. What we’re going to do today is we’re going to go through a similar set of examples, with each different type of entity. So, we’re going to make the same assumptions on all of them.

Those assumptions are that this business has $100,000 of net income. We have a new person coming in for the live webcast. Eric, have a seat. We’ll go through and look at all these examples, again, making the same assumption, $100,000 of net business income. We’re going to assume that the owner is in a 35% tax bracket, but doesn’t have any other self employment or earned income.

Here we go with the first slide. We’re going to look at a C corporation.

The C corporation has $100,000 of net income. C corporations, unlike other types of entities, pay their own tax. It’s a separate entity, and it pays its own tax. The tax rates start out fairly preferential for a C corporation. The first $50,000 is taxed at 15%. A C corporation with

$100,000 profit you’re going to pay corporate income tax of $22,250. That’s going to leave the corporation with $77, 250 in the corporate bank account. The owner doesn’t yet have that money. It’s in the corporate bank account.

You may have heard of the double taxation you have with C corporations.

That is, in fact, true. To get that money from the corporate bank account to the owner’s bank account, there is tax involved in that. That payment is a dividend. In this example, we have a dividend of $77,250 to the owner.

That dividend is subject to income tax. Now, that income tax used to be, before the Bush tax cuts, that dividend was taxed at our ordinary income tax rate, which, about a decade ago, before the Bush tax cuts, was taxed at the highest rate of 39.6%. Now you get that preferential dividend rate of 15%. Keeping in mind, this is the second time this income has been taxed.

The owner’s going to pay dividend tax of $11,588 on this. You started out with $100,000 of earnings after paying all of your business expenses, except taxes, and you are left with $65,662 to purchase groceries.

In the next example, we’re, again, going to look at a C corporation . . .

but we’re going to use a little bit different strategy in getting the earnings to the owner. Instead of paying a dividend, we’re going to pay the owner a wage. Now, we are not able to pay out the entire $100,000 as wage, because there is employment taxes involved on the wages, of course. The most we could pay out to the owner is $93,000. The rest of it has to be paid in employment tax. There’s the $7,000 of employment tax.

Going to the next slide, the owners got a wage of $93,000. We will use the same assumption that they are in a 35% tax bracket. They are going to pay individual income tax of $32,513. Now, just as the corporation had employment taxes, you as an employee also have employment tax. All of us that have W-2 jobs have Social Security and Medicare taken out of our wage. That’s what makes up this additional $7,000 of employment tax. That leaves this owner with $53,275 to purchase groceries. Remember, we started out with $100,000 after all of our business expenses except for taxes, and this is what we end up with.

Going on to the next slide . . .

I tend to march through this pretty fast, if you have questions feel free to pop in there in the chat box, and I’ll try to look over there once in a while, sometimes I miss it. Most often are sole proprietors, rather than any type of corporation. That’s what we’ll look at in this next example. Now, I don’t have a separate slide for an LLC. The reason I don’t, is because a single member LLC that has not made an election to be taxed as something different is treated as a sole proprietor for tax purposes, because the LLC is a disregarded entity, as far as the IRS is concerned. This applies to a PLLC, also.

This slide not only addresses the sole proprietor, but also addresses the LLC. Again, we’ll go through the same example except this time with a sole proprietor or an LLC. We start out with $100,000 of profit. We’re going to have individual income tax $32,527. The reason we don’t have $35,000 of income tax, remember they are in a 35% income tax bracket, is that half of yourself employment tax is deductible for determining your income tax.

Also, we have self employment tax of $14,130. That’s going to leave this person with $53,343 to purchase groceries or whatever they want. As you see by the slide, that tax burden is somewhat onerous, as you see by the man with the ball and chain at the bottom. One of the best ways that I’ve found of helping small businesses is getting out of this situation. Rather than paying that amount, and one of the big problems here is not the income tax.

This person is in the 35% bracket, which means that they make a lot more money than just this $100,000. They have income from other sources. The big meany here is this self employment tax, because that is 15.3% on top of that 35% income tax bracket. That’s a lot of what we deal with is attacking that self employment tax. One of the ways we do that is with an S corporation.

Now, let me add a little caveat here. I don’t want people to come away from this presentation thinking that, “Oh, John Huddleston said that an S corporation is the best type of entity, the most tax advantaged entity.” You can’t truthfully make a blanket statement like that because you have to look at all of your facts and circumstances and determine what’s going to be best for you.

I have found, through an S corporation, that I can reduce taxes for a lot of small business owners. Let’s go through this example. Again, we’ve got $100,000 of profit after our business expenses. Now, a S corporation is different from a C corporation. It is still a separate entity, but it’s different in the sense that it’s a flow-through. By flow-through, I mean all of the profits or losses flow-through to the owners. The S corporation rarely pays income tax.

Rather, it’s the owners that pay the income tax on that income. You don’t have the double taxation that you have with a C corporation. Unlike the sole proprietor or the LLC, the profits of an S corporation are not subject to self employment tax. As we go through this, there’s $0.00 income tax at the corporate level, so $100,000 of profit after corporate tax.

Going to the next slide, that money still has to get to the owner.

Regardless of if it’s distributor or not, the owner is going to be taxed on this income, again, because it’s a flow-through. The owner, being in a 35% tax bracket, is going to pay $35,000 of individual income tax. That’s going to leave them with $65,000 to buy groceries. That’s a better scenario than what we had back with the sole proprietor . . .

that was left with $53,000 to purchase groceries. We’ve saved $12,000 here.

Now, people might be thinking, “That’s still a lot of income tax.” But keep in mind, this person is in that 35% income tax bracket. In order to lower that, we’ve got to deal with this $100,000 figure, looking at how we can reduce that. Perhaps through retirement plans and such, we can lower that number.

This person is in a high tax bracket. They have done better than the sole proprietor and ended up with $65,000. The problem here is that this person is working for this business. When you are working for your business, if you’re an S corporation, you are required to pay yourself a reasonable salary. That wasn’t done in this scenario. That’s the reason for this next slide, which is a bit of an overstatement . . .

you won’t actually go to jail, but you will likely get audited, and you will likely not do well on that audit. When you complete an S corporation return, one of the first lines on the return says, “Officer compensation”. It’s right there on the front page, what the owners are paid. You want some amount in that line, hopefully, it’s a reasonable amount.

If we pay out all of the profits as wage, we might as well not be an S corporation. If we pay out all of the profits as wage, we end up with the same slide we had before with the C corporation that paid out everything to the owner as wage.

We didn’t end up in a very good situation there.

That’s what we’ll look at with this next slide.

We’ll look at an S corporation that has $100,000 as profit and pays out a wage to the owner of $20,000. Now, you might be thinking, “$20,000, that really doesn’t sound like a reasonable wage. That’s aggressively low.” And, yeah, that very likely could be.

There are examples when that could be a reasonable wage. Maybe this owner doesn’t work very many hours for this business. Maybe it is a very capital intensive business. But, at any rate, we’re going to assume that this is a reasonable wage. So, there is $0.00 corporate income tax, because S corporations don’t pay income tax. There’s $1,500 of employment tax that the corporation has to pay.

Going to the next slide . . .

and that leaves us $78,000 that can flow-through to the owner. In addition to that, the owner is getting the $20,000 wage. Again, the owner is in the 35% tax bracket, they are going to pay $34,465 in income tax.

Also, just like all of us with W-2 jobs, they are going to have Social Security and Medicare withheld from their paycheck. They are going to pay employment tax on the employee side of $1,530. That’s going to leave this person with $52,475 to purchase groceries. So, we ended up about $9,000 better than the sole proprietor or the LLC in this example:

Hopefully, you’ve got the picture that the way you save money with this is to have some amount of difference between the total profit and that reasonable salary amount.

If there is a fair amount of spread between the total profit and the reasonable salary, then you can make money on that difference. You can save self employment tax on that difference.

The trick is to pay yourself the smallest amount possible but still have that be reasonable compensation. Everybody wants the formula for that, and there is no formula. You just have to look at all of the facts and circumstances. One of the things that you might look at, is where are those profits coming from? If the profits are coming from your capital investment, or if the profits are coming from the leverage that you have from employees, that would suggest that there could be a greater allocation towards profit and a light allocation towards salary.

On the other hand, if there is no capital investment and there are no employees, you’re just being paid for your hours, that would suggest that almost all of the allocation should be towards salary. You might look at what it would cost to hire someone to do what you do. If you weren’t working for this business, you wouldn’t be required to pay yourself a reasonable compensation.

If you hired somebody else to do what you do for this business, what would it cost? How aggressive do you want to be with that number? Do you want to be conservative or do you want to be very aggressive and have a lower salary?

Again, all of the facts and circumstances go into this. The salary should be a reasonable amount, it should be paid regularly. It’s also a good idea to have minutes that will document your salary policy, backed up by some research. You could do some research at Salaries.com or some other place to help you come to your decision. Also, document that decision. If that’s documented contemporaneously, as opposed to doing all this research when you’re in an audit, it’s going to help. The IRS is more likely to respect your decision that was made back at that time. Those are some things to look at.

What some people do that have S corporations is, they don’t pay themselves a salary throughout the year, then in December, they look at what their profit was and decide what it should be at that time. You can do that. There’s no requirement as far as when you have to pay your salary. That strategy is helpful in that you’ve delayed paying your employment tax an entire year.

If you take distributions throughout the year, you don’t have to pay employment taxes on those distributions. And then you pay out your salary all in December. Well, if you’re a monthly depositor, your employment taxes aren’t due until January 15th. You’ve deferred by a year, the obligation to pay your employment taxes.

But the problem is that if it’s all paid at the end of the year, it doesn’t look like a reasonable salary. I advise my clients to pay their salary on a regular basis, perhaps once a month. You can have a bonus amount at the end of the year, if you like. But, again, all of the facts and circumstances are considered in determining whether this is a reasonable salary. Best to have it a regular amount.

If it’s not a reasonable salary, what can the IRS do?

Well, if you don’t make any distributions, there’s really nothing they can do. The IRS power is to relabel transactions. If you took an amount from your S corporation and you called it a profit distribution or you called it a loan to share holder, the IRS has the power to relabel that transaction as salary. If they do that, then you are arguing with them about whether you are going to have to pay penalties or not on that, because if it’s salary, you didn’t pay the employment tax. Then, there are penalties on that, as well.

If there are no distributions, there’s really nothing the IRS can do. They can’t create a transaction. If your salary is too small, you have an increased chance of audit and an increased chance of paying penalties on that audit. I tried to come up with a way to illustrate this point . . .

of the reasonable salary, and there is a saying that’s been around for years, I didn’t come up with it, perhaps you’ve heard it before. The saying is, “That pigs get fed and that hogs get slaughtered.” The point being, if you’re just a little piggish, your salary is a bit less than the total profit, you can save some money, you can reduce your taxes that way. If you’re a hog and your salary is $0.00 or very close to $0.00, you’re going to get slaughtered, you’re going to get audited and you’re going to pay penalties on that audit.

This graph illustrates that saying. This blue line here represents your tax savings from having an S corporation. As this amount increases here, what we’re increasing as we go to the right is the amount that is distributed as profits as opposed to salary. If you distribute everything to yourself as profit and pay $0.00 salary, you’ve maximized your tax savings with the S corporation. If you pay everything out as salary and you have no profit distributions, then you have $0.00 tax savings from an S corporation. You might as well be an LLC in that example.

This blue line represents the tax savings from being an S corporation, notice that this line is linear. As you increase or decrease your salary or, actually, as this is illustrated increase or decrease the profit distribution, you will affect your audit risk. At this end, when we’re paying ourselves everything out as salary, we have minimized our audit risk. We always have some audit risk, so notice it’s not zero, but we’ve minimized our audit risk there.

As we increase the amount that we take as a profit distribution instead of as salary, you’ll notice that our audit risk goes up slightly. Until we get to this end of the graph, when our salary gets to be very small, we’re taking almost everything as profit distribution. You’ll notice that the audit risk not only is increasing, but is increasing at an increasing rate. It’s really skyrocketing at this end of the graph. This is not the place on the graph you want to be.

Yes, you’ve maximized your tax savings, but you may end up losing that, plus penalties on an audit. It’s much better to be in this part of the graph, where you tax savings exceed your audit risk. You’ve paid yourself a reasonable salary. That salary is not 100% of the profit, so you’ve saved yourself some tax savings with the S corporation.

The self employment tax is not the only thing to consider. You’ve got to take some other things into consideration. The home office deduction is not as inviting with an S corporation as it is with a C corporation, an LLC, or a sole proprietor. With an S corporation many CPAs end up taking it directly against the S corporation income, but the correct way to treat it would be as an unreimbursed employee expense.

That’s a miscellaneous itemized deduction, it’s only deductible to the extent it exceeds 2% of your adjusted gross income. If your adjusted gross income is $100,000, you’re going to lost $2,000 of that deduction. That’s not $2,000 of tax savings. It depends on what tax bracket you’re in. If you’re in a 25% tax bracket, $2,000 of deduction is going to represent $500 of tax savings or tax loss, in this example.

The other thing is that the S corporation may represent more administration for you. If you are a sole proprietor or a single member LLC, as I mentioned before, that’s a disregarded entity as far as the IRS is concerned. Your activity is just included in schedule C of your return. If you’re an S corporation, you have a separate income tax return to complete.

Now, also if you don’t already have employees, becoming an S corporation and adopting this strategy means you’re going to become an employee of your company. So, now you’ve got payroll returns to complete. This doesn’t really matter if you already have employees, all your administration is added by the first employee, so it’s not a big deal to add one more employee. If you don’t have employees, then that’s something you have to consider. That’s extra administrative cost.

There was some pending legislation to get rid of this tax loophole, you might say. . .

The legislation failed. You can look at the statute and see why it failed. The way the statute was drafted, it was going to make the profits of S corporations subject to self employment tax, if the principle asset is the reputation and skill of three or fewer employees, and also, if it was in one of these industries. Well, that’s clearly an attack at small business. Small business is usually the good guy, so they decided to leave this alone. It could come back in the future, though.

The last two slides are just the tax rates for corporate income tax and the married filing joint rates. In the next couple of days we will email a .pdf of all of these slides to everybody, so you’ll have that.

Any questions at this time?

I’m sure there are things that I am forgetting. I guess maybe they’ll come to me, or someone will have a question about it. If there are no more questions, I’m sure someone will come up with a question as I’m wrapping this up, but I just want to point out that we’ve got webcasts coming up.

I know one of the things I forgot about, it was our poll question.

Some of you received a poll question in the past couple days. The poll question was asking, “What do you think is the most tax friendly entity-type for small business?” You can see the results here, we didn’t have too many people vote, we only had five votes, but as always, the LLC was the leading vote getter. Also, although we didn’t have many votes, the sole proprietorship didn’t get any votes.

Now I asked this same question on LinkedIn, and had 50 responses. The results were pretty similar. The LLC was the leading answer, and the sole proprietorship was the loser. Which is very interesting because the LLC, unless you make the election to be taxed as something different, if you’re a single member LLC for tax purposes you are a sole proprietor. So, it’s very interesting that the LLC is always the leading vote-getter for this question and the sole proprietor is always last. I’m not quite sure what the reason for that is, but perhaps your vote would be different now, after the presentation.

The other thing I forgot is that, if you have an LLC or a PLLC and you watched this presentation and thought, “Well, I wish I would have become an S corporation instead.” You don’t need to abandon your entity to create a new S corporation. You can simply make an election with the IRS that your LLC be taxed as an S corporation. You see, there’s no such thing as an LLC tax return, so the IRS has to decide which category you fall in. By default you’re one thing but you can elect to be something different. A single member LLC is treated by default as a sole proprietor. If you have more than one member and you’re an LLC you’re treated by default as a partnership.

That’s another thing I forgot, people might think, “Well, I didn’t address the partnerships.” The slide regarding the LLC and the sole proprietorship really is the same slide for a partnership. Just figure if your share of the partnership’s profits is $100,000, your tax scenario is going to be the same as that slide I showed with the sole proprietor. I’ll go back to it:

Again, LLC, sole proprietor and partnership: if your share of the partnership is $100,000 and you’re in the 35% tax bracket, you’re going to pay this amount of individual income tax, $32,527. All of those profits are subject to self employment tax. You are going to pay $14,000 in self employment tax. You are going to end up with $53,000.

I see Kathleen had a question,” What did you say about the home office deduction and the best entity to use?” What I was saying, is that with the S corporation the home office is not as attractive. With a sole proprietor, a partnership, or an LLC, the home office deduction is deductible 100% against the profits of your sole proprietor, your LLC, your partnership. That is not the case with an S corporation.

With an S corporation that home office deduction is a miscellaneous itemized deduction. So, first of all, you have to itemize. People that itemize have a lot of mortgage interest or in other states they pay a lot of state income tax. Second of all, it’s a miscellaneous itemized deduction, which means you are going to lose the first 2% of your adjusted gross income.

It can work out fine with a C corporation because you can just end up renting to your C corporation, there’s no limitation there. It works out fine with a C corporation. It works out fine with an LLC, sole proprietor, and partnership. It’s not as good of a deduction with the S corporation. You have to weight that along with any potential self employment tax savings that you have with an S corporation.

Catherine is asking, “What is the deadline for the sub S election?” The deadline is March 15th, unfortunately. It has to be made in the first 75 days of creating the entity or the first 75 days of the tax year for which it is to apply. If you want it to apply for 2011, you are supposed to make that election by March 15th. Now, I’ve had some good success making a retroactive election. We have to show reasonable cause on why the election was not made, but the IRS tends to be fairly forgiving in making that retroactive election. But, best to make it by March 15th.

Michelle is asking, “What arrangement would you recommend for a free lance writer?” Well, for a free lance writer, I guess you’d have to look at, I’m assuming you’re not going to have employees. I’m also assuming you’re not going to have a very significant capital investment. You’re going to need to take that into consideration when you decide what a reasonable wage would be. We’d have to take a look at what your total profit is going to be, what you’re going to pay yourself as a reasonable wage.

I never make that determination for the client. You really have to come up with that yourself, what a reasonable wage would be. It’s your industry. You know what people are paid in your industry. You know how aggressive you want to be, or how conservative you want to be with the IRS. We would have to look at that, and if there’s not enough difference between that reasonable wage and the total profit, then an S corporation is not going to work. On the other hand, if that reasonable wage can be a bit less than your total profit, then, yes, even as a free lance writer an S corporation could have some tax savings for you.

Phyllis is asking, “It is my understanding that if you live and work from a rent controlled apartment it is best not to claim home office deductions so you don’t lose the rent controlled apartment. I am in New York City.” I have no idea what the laws are with regard to maintaining the rent control on your apartment, so I’m sorry I can’t help you with that.

Michelle: Right no employees, right on the capital investment being fairly low.

Anne is asking, “What are the potential tax consequences of making an S corporation election several years after the formation as a C corporation? What are the accounting steps?” There are some complicated issues here that have to be looked at. One of those has to do with the retained earnings of the C corporation. The IRS doesn’t want to lose out on that second level of tax. Remember with the C corporation, it paid tax and then it paid a dividend to the owner, and the owner was taxed again on that income.

Let’s say you have a C corporation and for years it was not paying you dividends, or at least not distributing all the retained earnings to the owner, so that this was building up. There’s an issue there if you were to make an election to be taxed as an S Corporation, the IRS wants to collect some of that money there. It is beyond the scope of this presentation to go into what that calculation is, but that’s definitely an issue. There’s going to be some tax consequences of doing that if you have retained earnings built up in your C corporation. Also, there’s something called built in gains in your assets. That could create a taxable event for you if you make the conversion to an S corporation. Those are definitely things you would want to consider.

Again, if you find this helpful please tell your friends about this webcast, which is going to be presented again on May 18th. If you haven’t seen any of our other webcasts and you think those might be helpful, take a look at those. You can see them on the events page at smallbusinesswebcasts.com. We also have small business articles at smallbusinesswebcasts.com. After tax season is over, we’re going to start adding those at a faster rate.

My name is John Huddleston. I’m a CPA for Huddleston Tax CPAs here in Seattle. We help small businesses in the greater Seattle area and across the country in fact, with their tax issues. We do returns for all the states including your federal return. We help with payroll issues, book keeping, tax planning, tax preparation, small business evaluation. Whatever the tax and accounting needs are of small business owners are, that tends to be what we do.

I’d like to thank everybody for attending today. I don’t see any questions from the webcast attendees. We have a small live audience of three people. If you have any questions I’d be happy to answer them. If not, I’m going to end the webcast. Have a good day.

Huddleston Tax CPAs of Seattle & Bellevue
Certified Public Accountants Focused on Small Business

(800) 376-1785
40 Lake Bellevue Suite 100, Bellevue, WA 98005

Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.