Different Business Structures & Your Tax Bill
This article was originally posted on Halon Tax and written by Christopher Ragain, CPA.
Almost every day I see several questions from business owners and accountants as to what the differences are with different business structures. These questions range from “Which is the best structure?” to “With the new tax law shouldn’t everyone be a C-corporation?”.
Most professionals who know the differences like to say “It depends.” While this is an accurate answer, it can be frustrating if you are trying to get to the answer and get on with your day.
This article is going to go deep into these questions and talk about “What it depends on” so you can make some decisions about the best structure for you.
To get into the details, we have first to make sure you understand the nomenclature and define several terms you are going to read in the rest of the article. Let’s dive into that now.
LEGAL ENTITY VS TAX STRUCTURE
One of the most confusing elements of talking business structures and taxes has to do with what everything is called. Words like CORPORATION, COMPANY, & SOLE PROPRIETOR probably bring to your mind a single idea… your concept of a business. However, they mean several different things depending on the context and the specific verbiage:
I want you to familiarize yourself with the concept of:
Legal Entity: A legal entity is a business or operation that has registered with the state it operates in, and possibly other states as well. The state grants this entity, and it is formed to allocate ownership, provide limited liability, and so the state can manage the names of businesses and what kinds of companies are conducting business in their state.
Examples of legal entities that most states offer are:
LLC (Limited Liability Company)
PC (Professional Corporation)
LLP (Limited Liability Partnership)
Fictitious Name (allows you to use a name, is not a real entity, just lets you use it)
Tax Structure: A tax structure is a taxation classification given to your business by the IRS. This classification will determine how you are taxed in your business. Each classification has very different attributes, and your tax bill can vary significantly based on which you choose.
Examples of tax structures are:
Disregarded Entity (Sole Proprietorship)
They are different things, but some of the categories in each have the same names. Let me show you:
As you can see, the Legal Entity options have the word corporation in them, as do the tax structure categories. In many cases, if you hear the word “Corporation,” you would have no real idea what that is.
To make things more confusing, legal entities can elect many types of tax structures. These choices mean that if you have an LLC, you could elect a tax structure for that LLC in different ways.
Here are some examples:
Joe starts a plumbing business and goes on his states secretary of state website or hires a professional and sets up an LLC. Joe is the only owner of the company.
By default, if he does nothing else after he sets up the LLC, the IRS will automatically make him a disregarded entity (sole proprietorship) as a tax structure.
However, he has several options to change if he wants. He can switch to an S-Corporation or a C-Corporation if he wants to. To do that, he simply files some forms with the IRS, and it changes.
He is still called an LLC, the company name is still Joe’s Plumbing LLC, but his tax structure would be an S-Corporation or C-Corporation.
Same as example #1, Joe is setting up an LLC. Only this time, there are two owners. He and his good friend Pat are going to own the business 50-50.
The name and legal entity are the same; it is an LLC. However, the default tax structure from the IRS is different. Because he has a partner, more than one person in the business, the IRS says the tax structure by default is a partnership.
However, same as in example #1, the LLC has other tax structure options. It can be an S-Corporation or a C-Corporation. Again, the name would be the same, only the tax structure changes.
Donna decides to start a flower shop. She starts a Corporation by filing with the state or hiring a professional to do it for her. Her company is called Donna’s Flowers. She is the only owner.
When you set up a corporation, you can’t use LLC behind the name, but you can use Corp. or Corporation or Inc. So she decides on Donna’s Flowers Inc. This set up is all done through the state, just like someone starting an LLC.
Also, just like with an LLC, Donna’s corporation has options when it comes to her tax structure. By default, the IRS says any corporation is classified with the tax structure C-Corporation unless it changes it.
Corporations can elect tax structures of C-Corporation (default) or S-Corporation.
Even if Donna had another partner that owned the corporation with her, the options are the same. A corporation cannot be a partnership.
Erik decides to open a Drywall business. He does not file anything with the state other than a fictitious name registration so he can use the name “Erik’s Drywall” and accept checks with that name on it.
Erik has not set up a legal entity. He has no legal protections; he just has a name he can use. This type of setup is dangerous and should never be used. For more information on that, you can download my eBook “The Dangers of Sole Proprietorship” here.
Because Erik has not set up a legal entity, he has no choices when it comes to the tax structure. He is stuck with the default, which is a disregarded entity (sole proprietorship).
If Erik had a partner with him, they would be called a general partnership. Still, because there is no legal entity, there are no tax structure choices. They are stuck with the default partnership classification from the IRS.
Now that you have a clear understanding of what is a legal entity and what is a tax structure, the rest of the article is about comparing the different tax structures.
PARTNERSHIPS AND SOLE PROPRIETORSHIPS
When it comes to tax structures, the partnership and sole proprietorship are the same in almost every way. The only difference is that sole props are for one owner businesses and partnerships are for multi-owner businesses.
When it comes to their benefits, the list is short. They are simple to set up. That’s about it.
The disadvantages to sole proprietorships are many. First, as a tax structure, you are getting the full weight of taxes with these. You will pay regular income tax and self-employment tax on your income from these businesses. Let’s define regular income tax and self-employment tax as we are going to be using the terms quite a bit.
Regular Income Tax: This is the tax you remember most of your working life. This is the tax that the news and the government talk about all the time. It starts at 10% of your income and can go as high as about 40%. They base this on your taxable income, which is all your income minus all of your deductions. So you get to subtract your mortgage interest, charity, all of that before you apply the tax rate to what is left.
Self-Employment Tax: This is a tax that only applies to self-employed persons. It is 15.3% up to about $130K of income, then 2.9% of everything after that. They base it on your business’ profits, so it does not allow subtractions for personal mortgage interest, charity, or kids. It can be a nasty tax because even if you have lots of personal deductions, this tax still shows up in large amounts. It is related to the payroll tax FICA, as I will explain below.
FICA (the social security and Medicare tax): This is the payroll tax you have paid on your wages every year of your working life. It is 7.65% paid on your payroll up to about 130K, then 1.45% after that. It is half of the self-employment tax. That is because your employer paid the other half. See how FICA and self-employment tax are the same? Because you are self-employed, you pay both the employee and employer side. Moreover, it is calculated in both instances simply on the income you earn, no personal deductions or credits are allowed to offset the business income.
So, with a partnership, you pay both regular income tax and self-employment tax. Let’s take a look at an in-depth example:
As you can see, at the bottom we see total tax is $38,844 with $18,868 of regular income tax and $19,976.00 of self-employment tax.
The Self-Employment Tax is MORE than the Regular Income Tax!
This example shows clearly just how bad the self-employment tax (or SE tax) can get.
If you make less than $20,000 profit, the sole prop or partnership tax structure is not a bad option. Because the income is so low, you won’t have too bad a tax hit. If you make more than $20K, there are better tax structure options for you, as I will outline below.
Now while I said I was going to show you better options, this one is probably not for you.
The C-Corporation tax structure got lots of airtime this year with the tax law overhaul. Because the tax rate for corporations was dropped from the 35% tax rate down to 21%. Corporate America cheered, and business owners saw this and said “Hey, I want to get in on that!” and started considering changing their tax structure to a C-corporation.
Alas, this will not work because the problem is in the details…
A C-Corporation has very different attributes than other tax structures. It is not a pass-through entity.
Pass-Through Entity: A set of tax structures (Partnership, Disregarded Entity/Sole Prop, S-Corporation) that does not pay tax at the corporate level. Instead, the income of the business passes through to the individual to pay on their individual tax return. This pass-through results in the owner paying tax once, on their personal return, at personal tax rates.
That is a fancy way of saying, other tax structures pay tax one time. C-Corporations pay tax twice! It is called double-taxation. Let me show you how it works:
Jessica opens an online store that sells makeup. She has a professional create a corporation for her business (remember, a legal entity). She does not elect a different kind of tax structure, so her corporation uses the default structure: C-Corporation.
In her first year of business, Jessica does very well. She has an income of $300,000 and expenses of $200,000, so her company made a profit of $100,000.
Then she does her C-Corporation tax return. It shows that she owes 21% tax on the $100,000 she made. Just like the new tax law said she would, so far so good…
She pays the tax ($21,000) out of her business and keeps the $79,000 of the profit for herself.
When she distributes that money from her corporation to her personal checking account, however, another transaction has just occurred.
She just received a dividend, and dividends are taxable on her personal return.
That $79,000 is reported as a dividend on her personal tax return, and she now owes 15% tax on it. That comes out to $11,850 in more tax. So she paid tax at the corporate level, and tax at the personal level.
That is double taxation, and in almost every calculation, it means more tax gets paid by a C-Corporation than any other tax structure. I have a calculator I will show you later, so you do the math for yourself.
Jessica ended up paying a total of $32,850 on her C-Corporation. To compare, using the same variables, if she was a Sole Proprietorship, she would have only paid $29,653.
So remember to ignore all the hype, the C-Corporation is probably the worst tax structure a small business could elect.
However, I have another structure to show you, one that is way better than either of these in 99% of cases.
The S-Corporation. The tax structure that stands above them all. It is better because it has an advantage. Really it’s an unfair advantage, one that Congress gave it with the express intent of making it better than the others options…. Want to know what that advantage is?
It does not have to pay self-employment tax!
NO SE TAX!
NO SE TAX!
NO SE TAX!
The S-Corporation does not require the owners to pay self-employment tax on the dividend income from the S-Corporation.
This perk really is wonderful. While I don’t want to diminish the joy and excitement, I know you are feeling right this moment….
I have not mentioned some of the requirements that S-Corporations must comply with, and by complying with them, it reduces some of the savings.
The S-Corporation owner does not get to avoid 100% of the self-employment tax. When Congress and the IRS rendered the rules for S-Corporations, they threw in a concept called reasonable compensation.
For a technical definition, you can read it here: https://www.irs.gov/newsroom/wage-compensation-for-s-corporation-officers
However here is what it means… If you are an officer of the corporation (and if you own an S-Corporation you are an officer), then you must be an employee of that corporation. If you are an employee of the corporation, then you must be paid a salary. If you receive a salary, it must be a reasonable salary. What is reasonable? Well, we will get into that in a bit.
What this means is that if you own an S-Corporation, you are going to have to run payroll on yourself. That means you are going to be paying some self-employment tax because… self-employment tax and FICA tax are the same things. They’re cousins.
So when you run payroll, you are going to pay half of the FICA through your wage (just like when you were employed for someone else) and your employer will pay the other half (which is still you, because it is your corporation and the corporation is paying the employer part of FICA).
Let me show you an example:
David owns an LLC (legal entity) that elected the tax structure of an S-Corporation. He is required to run a reasonable salary on himself, which he has calculated as $40K per year (I will show you how to do this later).
His business made $125,000 in income for the year, had expenses of $25,000 and paid his salary of $40,000. This means the LLC profit for the year was $60,000 ($125K – $25K – $40K = $60K).
Now, he really got more than that. He gets $60K to take home because he is 100% owner of the business and he got the $40K as an employee. So he took home $100K, but the business return shows $60K because to it, his salary is still an expense.
So that $60K is not subject to self-employment tax, but the $40K salary is because he paid FICA on that as it was paid. This means that he was able to avoid some but not all of the self-employment tax.
That’s good! Compare that to if he was a sole proprietorship…
In that case, he would not need the salary, and his profit would have been just $125K – $25K in expenses = $100K. However, he has to pay self-employment tax on all of that $100K.
By avoiding the self-employment tax on the $60K using an S-Corporation, he was able to save:
$60,000 x 15.3% = $9,180. So roughly $9K saved. That is a great saving, especially when you think of it year after year after year!
So let’s compare it to the Disregarded Entity/Sole Prop example we had before.
Look at that! Because we can reduce our self-employment tax, the S-Corporation is considerably better than a sole proprietorship or partnership. Now, let’s look at all the structures together:
As you can see, when compare to C-Corporations with and without payroll, the S-Corporation is the clear winner.
This result is fairly easy to see at any level. We have created a calculator at Halon Tax that you can use to see just how your business would do.
It is easy to use; you plug in your business type, number of owners, and what your profit is each year and you can see what your taxes would look like with each situation.
You can find that tool here:
SECTION 199A DEDUCTION
The new tax law passed for this year has in it a massive new deduction for businesses owners called the 199A Deduction or the Pass-Through Deduction. It allows for a 20% deduction of business income if you are a flow-through entity.
It is important to note, that the C-Corporation does not get this deduction. In fact, this was how the new C-Corporation tax rates got passed because legislators needed to give something to businesses that were not C-Corps to get enough votes.
I mention it, because many in the tax business may tell you that because of this new deduction, the S-Corporation is not nearly as beneficial. I would say that those people haven’t run the numbers. The calculator above includes the 199A calculation (which does not help you on self-employment tax, just regular income tax) and the S-Corp still wins.
Also, in the large examples above, you will see we have calculated the 199A Deduction for each entity that can receive it. Still, the S-Corporation is the best way to go.
So why isn’t every business in the US an S-Corporation tax structure if that is so great? Surely I am not the only one who knows this information right?
Believe me; most tax accountants know all of this. The reason they don’t elect S-Corps generally falls into one of 2 categories:
The owners of the company or some other element does not meet the requirements to be an S-Corp. The primary requirements are that owners have to be US citizens or resident aliens. Also, there can’t have more than 100 shareholders. However, this is not nearly as frequent the cause as category #2.
The cost of compliance. Most accountants want to charge vast sums of money to prepare S-Corporation tax returns, run payroll, do the bookkeeping, etc. So that cost can outweigh the benefits for smaller companies.
This cost was one of the major reasons we started Halon Tax.
The cost of doing tax returns was keeping business owners from electing the S-Corporation tax structure and that in general was harming the small business world.
You can see on our pricing page that our prices at Halon make it very easy to have an S-Corporation and not pay out the benefits to an accountant or CPA.
If you have any questions about any of this or any other tax issues in your business, please visit our website at www.halontax.com and open up the chat button in the lower right of every page. Our chat is staffed by trained accountants and CPAs that can answer any question you might have.