When first considering the benefits of forming
an entity for your business, it is natural to focus on liability
protections. Perhaps, it is even more
natural to focus on investors, particularly how many you anticipate and whether
you are open to granting equity in your business. However, this blog post highlights an
additional consideration that, in some circumstances, may be the primary factor
in determining which entity structure is best for your business: How will your business
be taxed? For the purpose of simplifying
this illustration, the Limited Liability Company (LLC) was selected for comparison
because of the prevalence at which it is selected and its specific
attractiveness to small businesses. This
blog post focuses narrowly on the specific tax benefits of the S Corporation (S
Corp) structure in comparison to the LLC structure.
https://images.app.goo.gl/qjGQeGWSGCkXqUxQ7
Beginning with the similarities, both the S
Corp and the LLC are subject to pass-through income. Pass-through simply means that the entity
itself is not taxed at the entity level; rather, the income generated by the
business is “passed through” to the owner(s) as ordinary income (i.e., as if it
were wage or salary income). This is key
for small businesses, and makes both entity structures more attractive, strictly
for tax purposes, relative to the C Corporation (C Corp) because neither is
subject to the risk of double taxation.
Double taxation is the phrase used to describe the phenomenon of taxing
C Corp profits at the entity level and then subsequently taxing any dividends
distributed to the shareholders of said C Corp.
This phenomenon will normally result in a marginal tax rate (i.e., the
tax rate incurred on each additional dollar of income) that exceeds the owner’s
personal marginal income tax rate, had all of the profit been passed through. For example, the corporate tax rate in the
United States is currently a flat tax of 21%, the highest tax bracket for long
term capital gains is 20%, and when aggregated, this equates to a marginal tax
rate of 41%. The highest tax bracket for
individual income in the United States is currently 37%. Thus, even before considering
complicated Federal Insurance Contributions Act (FICA) implications, having
profits pass through presents an opportunity for business owners to save a
minimum of 4% in marginal taxes by avoiding double taxation.
With
that in mind, we turn to the key distinction between the S Corp and the LLC: How
is self-employment tax applied?
Specifically, self-employment tax refers to FICA tax, which is currently
the combination of a 12.4% tax for Social Security and 2.9% tax for Medicare,
totaling 15.3%. For typical wage and
salary earners, this tax is split with one’s employer (i.e., half is paid by the
employer and the other half is paid by the individual). However, because self-employed business owners
do not have an employer to split their FICA tax with, they are responsible for
the entire 15.3%. This is true for the
salary income of both the S Corp and LLC structures (i.e., any income
identified as salary income will be subject to the 15.3% tax). However, this is where it gets interesting: With
an S Corp, shareholder distributions (i.e., payments made to shareholders in
addition to their salaries) are not subject to self-employment tax, whereas
with an LLC, they are. This means that owners
of S Corps are able to legally avoid paying the 15.3% self-employment tax on a
portion of their total income by making shareholder distributions instead of
solely paying out salaries, whereas LLCs do not have this option. This is a potentially massive opportunity to
increase post-tax income both for the business as an entity and its owner(s)
personally.
For
example, suppose that a small business nets $100,000 in pre-tax profit. Suppose also that there is a single owner who
wishes to extract all $100,000 as her personal income for the year. If this business is an LLC, no matter how she
designates the payments to herself (i.e., divides the $100,000 between salary
and shareholder distribution), she would be subject to the 15.3%
self-employment tax on the entire $100,000, equating to $15,300 in self-employment
tax in addition to her standard income taxes.
If, however, this business is an S Corp, the designation of the $100,000
would become incredibly relevant. For
example, if she paid herself a salary of $50,000 (assuming that is considered a
“reasonable salary for her position”), she could pay herself the additional
$50,000 in profit as a shareholder distribution, which would not be subject to
the self-employment tax. As a result,
she would only pay the 15.3% self-employment tax on $50,000, equating to $7,650
in self-employment tax in addition to her standard income taxes. This is the power of the S Corp. With no additional effort, the owner of this
small business is able to take home an additional $7,650 in post-tax income. As mentioned above, the caveat is that
salaries be reasonable. The Internal
Revenue Service (IRS) requires salaries paid to employees (including owners) to
be “reasonable compensation for the efforts they contribute to conducting their
trade or business” because it recognizes and is trying to mitigate instances,
such as this, of legal tax avoidance.
Selecting
the right entity structure for your business is a big decision. From liability protections, to complexities in
day-to-day operations, to tax benefits, there are substantial implications for
both the business and its owner(s). The self-employment tax issue should be
among the many considerations examined when making this important decision.
https://www.berkmansolutions.com/articles/entities/30-years-of-new-business-entities
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(Trends in entity formation selections,
nation-wide, over time)
https://www.co-oplaw.org/knowledge-base/entity/
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(Distinctions between different entity
structures)
https://www.michigan.gov/lara/0,4601,7-154-89334_61343_35413-114907--,00.html
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(Total count of different business entities
in the State of Michigan as of October 1, 2021)
https://www.irs.gov/businesses/small-businesses-self-employed/paying-yourself
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(Information regarding the procedures for
compensating yourself for your efforts in carrying on a trade or business)
https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2021
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(Federal marginal tax rates as of 2021)