There is a lot of confusion among small business owners when deciding on their entity classification and the tax savings involved. It is the first discussion I have with most business clients. It takes time to get pertinent information out so I decided it would be a good idea to write down.
There are five business entity choices, but it really is only three since two are default choices: sole proprietorship, partnership, limited liability company (and its close cousin, the limited liability partnership), regular corporation (also called a C corporation) and the S corporation. You default to a sole proprietorship if you are a one-person business or a partnership when two or more owners are involved.
Most attorneys feel every business ought to be an LLC. I agree with the attorneys on this and not only for legal reasons. I like to tell people LLCs are like tuna, it takes on the flavor of whatever you put it with. A single member LLC defaults to a sole proprietorship and joint owners to a partnership. There are no LLC tax forms (with the exception of the “check in the box” election form). A single member files a Schedule C on their personal return; a partnership files Form 1065 like any other partnership. Sole proprietor and partnership tax rules apply accordingly.
An LLC can also take on the flavor of a regular corporation or an S corporation by making a simple election. The “check in the box” election informs the IRS how you want to conduct your business. Most of you don’t want to follow regular corporation tax rules so you will file a second form electing to be treated as an S corporation.
Regular corporations pay their own taxes and dividends paid to the owners are not deductible by the corporation and are therefore double taxed. S corporation profits flow to the owner’s personal tax return and are only taxed on the personal level. Corporations must pay owners a reasonable wage. If you are wrapping your mind around this concept you will naturally want your wages from your LLC/S corporation as low as possible to avoid self-employment taxes on the pass-through profits. The IRS knows this and requires a reasonable wage, but reasonable is a wide road. The tax court is littered with cases on fair compensation. The IRS has provided a safe harbor of 60% of profit as a reasonable wage.
Example: You have an S corporation with $200,000 before owner’s payroll. Safe harbor for owner’s wages are $120,000.
Is it possible to have a lower wage and still be reasonable? Yes. A safe harbor is just that, a place where the IRS agrees not to challenge your position. Many owners will not use the safe harbor method. If you have employees (let’s say 20), a large portion of the profit is derived from said employees. Remember why S corporations exist. They allow small firms to conduct business without the negative tax rules of a large regular corporation while still maintaining the legal protection of the corporate structure. The concept of the S corporation is to allow profits from non-owner’s work (passive income) to flow through to the owners without the double taxation of regular corporation dividends or self-employment taxes on the profits derived from employees.
Small businesses frequently have several employees or subcontractors. A reasonable wage for owners may be higher or lower than 60%. Safe harbor is 60% so we can hang our hat on that nail as an owner’s wage ceiling. The higher the profits, the more likely the safe harbor will only be a guideline. There are several places online to find reasonable compensation numbers. Robert Half has a temp agency (Accountemps) that publishes reasonable compensation numbers for a large number of professionals; unemployment offices in most states do as well.
Before we start this part of the discussion I want to remind you I am not an attorney. I encourage you to consult a competent attorney if you have any questions. I only provide my understanding of LLC versus S corporation law as it pertains to taxes.
What is the difference between an LLC and S corporation? Both provide legal protection. It is easier to understand LLCs when you understand why they were created. LLCs were created for legal, medical, and accounting firms. The reason LLCs were needed for these industries is because regular corporation tax laws are devastating to service corporations (you pay the top tax rate on every dollar of profit) and S corporations back then could only have 25 owners (100 owners allowed now). The other drawback of a corporation is the liability issue of all-acts versus own-acts.
An attorney can explain all the different rules between an LLC and corporation, both C and S. We will not dive into those details. There is only one legal area we will review. Remember, I am not an attorney. What I share here is how I understand the laws regarding LLCs and corporations.
The difference between LLCs and corporations involves something called own-acts and all-acts. As I understand it, LLC owners are only liable for own-acts while corporation owners are liable for all-acts. This is easiest to understand with an illustration.
We will use a medical firm as our example. Suppose two groups of doctors get together to start a clinic. One group of doctors organizes as an S corporation, the other as an LLC. After some time in business both clinics suffer a malpractice lawsuit against one of their doctors. Unfortunately, both doctors lose their suit and own a huge settlement. In the S corporation, owners are liable for all-acts; therefore, all doctors are liable for the one doctor’s malpractice. The same situation happens in the LLC clinic. However, with an LLC, liability is only for own-acts; only the doctor sued is liable; the other doctors are protected from loss by the LLC.
Once again, review your situation with an attorney. Feel free to leave comments below. If I verify additional information, I will include it in a future edit.
Show me the Money
Now we get to the part I love the most, the money. How much money can you save in taxes with an LLC treated as an S corporation? To make it clearer for everyone I want to start with a really small company example and work up in size. We will assume our small business owner organized as a LLC from day one, but only elected to be treated as an S corporation at the appropriate time.
The micro business: We start our example with a small home-based business earning a modest $10,000 of profit per year. At this low level of profit electing to be treated as an S corporation is inadvisable. The cost of filing the extra tax return for the S corporation would eat up more than the tax savings. There is still one thing a business owner can do: rent out a portion of his home to his LLC.
Let me review the office in home rules. A single member LLC treated as a sole proprietor will follow office in home rules like a sole proprietor will with one additional option. The office in the home must be regular and exclusive. This means you can’t deduct a corner of the living room you use sometimes. The office in the home must be an exclusive area of the home (like a spare bedroom) and used only for the business.
The LLC is a person in the eyes of the law. (Remember Mitt Romney raising people’s ire when he said this on the campaign trail. He actually was right, even if his delivery could use some work.) Just because your business is reported with your personal tax return does not change the fact that the LLC is a person. Therefore, the LLC can rent space in your home from you. You must have a rent agreement between you and the LLC. You don’t need anything fancy. A simple commercial rental agreement will meet IRS requirements.
The LLC can deduct the full amount of the rent. With an office in the home it must be “regular and exclusive”. For a rent agreement between you and the LLC it only has to be for the benefit of the LLC, a much lower bar to hurdle.
Let me illustrate with some numbers:
Office in the home:
Safe harbor deduction of spare bedroom office used “regular and exclusive”: $720 ($5 per square foot x 144 (a 12×12 room))
Business profit after office in the home deduction: $9,280
Self-employment tax: $1,420 (we round numbers when we prepare taxes.
Income tax (assume 15% federal; 5% state): $1,856
Total taxes attributed to the business: $1420 + 1856 = $3,276 total tax
LLC renting space in your home:
Fair rental value of bedroom office, plus storage area of part of the garage and work area used in the basement: $500 per month; $6,000 per year
Business profit after office rent expense: $4000
Self-employment tax: $612
Rental income: $6,000 – rental portion of home expenses (mortgage interest, property tax, repairs and maintenance and depreciation) $720 (to keep consistent with the above example) = $5,280
Income tax: $4,000 (business profit) + $5,280 (rental profit) = $9,280 x 20% = $1856
Total taxes attributable to the business: $612 + $1,856 = $2,468
Total savings doing it the Wealthy Accountant way: $3,276 – $2,468 = $808
Not bad for a company only earning a $10,000 profit!
The next business we will review earns a $30,000 profit per year. I consider the $30,000 to $50,000 range a no-man’s zone. A $30,000 company can benefit from an LLC elected as an S corporation in some cases, depending on the industry. By the time you reach $50,000 it is easier to get enough tax benefits to offset the additional costs of an S corporation (payroll service expense and tax prep fee for the additional S corporation tax return). Our example will consider the LLC treated as an S corporation.
Our example will assume a small home-based business, but will not consider the LLC renting from you; I will incorporate that into the wage data which will give us nearly the exact same answer without getting to long here.
As a sole proprietor:
Self-employment tax: $4,590
Income tax federal and state at 20% combined: $6,000
Total tax: $10,590
Ouch! Now you can see why you start thinking of tax alternatives when your business starts generating $30,000 or more in profit. It becomes painful really fast.
As an S corporation:
Profit: $30,000 – $18,000 (owner’s wage) = $12,000
No self-employment tax.
Payroll tax: $18,000 x .153 = $2,754 (We will not consider unemployment taxes either.)
Income tax at 20%: $30,000 (profit plus wage) = $6,000
Total tax: $2,754 + $6,000 = $8,754
Total savings doing it the Wealthy Accountant way: $10,590 – $8,754 = $1,846
Better, but it still hurts having a business. Still, you get to keep over 6% more of your money.
As we move to higher levels of income we can introduce other methods of tax reduction. To keep our illustrations simple, however, I will review these additional tax cutting ideas in future posts. Always consider these illustrations as non-inclusive; there are always variables that will change the results. By painting a narrow brush stroke I can show how a strategy works in a vacuum.
The remainder of this post will provide a quick illustration of the tax savings for a non-home based S corporation over a sole proprietor at $50,000, $100,000, $150,000, $250,000, and $500,000 profit levels. Once we reach over $100,000 the Social Security portion of the self-employment/FICA tax begins to reach its threshold and the tax savings change. I’ll point this out when we get there.
Self-employment tax: $7,650
Income tax federal and state at 20% combined: $10,000
Total tax: $7,650 + $10,000 = $17,650
Profit: $50,000 – $30,000 (owner’s wage) = $20,000
No self-employment tax.
Payroll tax: $30,000 x .153 = $4,590
Income tax at 20%: $50,000 (profit plus wage) = $10,000
Total tax: $4,590 + $10,000 = $14,590
Total savings doing it the Wealthy Accountant way: $17,650 – $14,590 = $3,060
Self-employment tax: $15,300
Income tax federal and state at 25% combined: $25,000
Total tax: $15,300 + $25,000 = $40,300
Profit: $100,000 – $60,000 (owner’s wage) = $40,000
No self-employment tax.
Payroll tax: $60,000 x .153 = $9,180
Income tax at 25%: $100,000 (profit plus wage) = $25,000
Total tax: $9,180 + $25,000 = $34,180
Total savings doing it the Wealthy Accountant way: $40,300 – $34,180 = $6,120
At this point I assume there are employees of the S corporation other than owners and reasonable owner’s wages are less than the 60% safe harbor. The Social Security limit is $118,500 for 2016. Wages or profits (for sole proprietors) above this level only pay the 2.9 % Medicare portion of the self-employment tax or FICA tax (both employee and employer share).
Self-employment tax: $19,044
Income tax federal and state at 30% combined: $45,000
Total tax: $19,044 + $45,000 = $64,044
Profit: $150,000 – $70,000 (owner’s wage) = $80,000
No self-employment tax.
Payroll tax: $70,000 x .153 = $10,710
Income tax at 30%: $50,000 (profit plus wage) = $45,000
Total tax: $10,170 + $45,000 = $55,170
Total savings doing it the Wealthy Accountant way: $64,044 – $55,170 = $8,874
Self-employment tax: $21,944
Income tax federal and state at 40% combined: $100,000
Total tax: $21,944 + $100,000 = $121,944
Profit: $250,000 – $100,000 (owner’s wage) = $150,000
No self-employment tax.
Payroll tax: $100,000 x .153 = $15,300
Income tax at 40%: $250,000 (profit plus wage) = $100,000
Total tax: $15,300 + $100,000 = $115,300
Total savings doing it the Wealthy Accountant way: $121,944 – $115,300 = $6,644
Note: There is a bubble effect once your income hits a certain level. Your tax savings may decline if you don’t apply other tax strategies. Working in a vacuum illustrates how the tax saving affect different income levels.
Our final example will not consider and Affordable Healthcare taxes.
Self-employment tax: $29,194
Income tax federal and state at 40% combined: $200,000
Total tax: $29,194 + $200,000 = $229,194
Profit: $500,000 – $100,000 (owner’s wage) = $400,000
No self-employment tax.
Payroll tax: $100,000 x .153 = $15,300
Income tax at 40%: $500,000 (profit plus wage) = $200,000
Total tax: $15,300 + $200,000 = $215,300
Total savings doing it the Wealthy Accountant way: $229,194 – $215,300 = $13,894
A final thought: This area of tax law covers a complex issue. It is not the only tax cutting strategy a business can use, but a very important one. It is of vital importance to business owners if they wish to survive. Several factors could slightly diminish the illustrated tax advantages shown while a significant number of other tax opportunities can reduce the tax liability. If you started as a partnership, the tax savings approximately double, especially for a husband/wife partnership. Knocking $25,000 off the tax bill is meaningful money.
Even if you prepare your own taxes, a tax professional should help you set up your business entity and help you determine reasonable wages. So many factors can change the results. Your situation will differ based on facts and circumstances.
Note: I received many questions on forming an LLC or corporation. In my office we used a company for years called The Company Corporation. You can check out their service by clicking the highlighted text.They handle all U.S states.
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