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How Tax Benefits Can Make Structuring as a S Corp Optimal

 

        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.  

  By Alex Butler

 

 Additional Sources of Helpful Information:

https://www.berkmansolutions.com/articles/entities/30-years-of-new-business-entities

-        (Trends in entity formation selections, nation-wide, over time)

https://www.co-oplaw.org/knowledge-base/entity/

-        (Distinctions between different entity structures)

https://www.michigan.gov/lara/0,4601,7-154-89334_61343_35413-114907--,00.html

-        (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

-        (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

-        (Federal marginal tax rates as of 2021)

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