Choosing a Form of Business: Options & Factors to ConsiderFeb 20, 2021
When you own a business, you may hear about electing S-Corporation status. Learn what that means and what factors you may want to consider before making this choice.
Tax law change and QBI
Prior to 2018, many small businesses formed an S-Corp once their business made a decent annual profit, over $50,000 or sometimes over $100,000. This is because an S-Corp reduces the social security and medicare tax paid by the business owner. Social security and medicare tax can be as much as 15.3% of business profit for a sole proprietor or LLC business and the opportunity to save 15.3% on a portion of earnings is appealing.
However, in 2018 the tax law changed. Small businesses received a new deduction of up to 20%, significantly reducing income tax for most small businesses. This Qualified Business Income (QBI) deduction applies to pass through income from business. It provides more of a benefit to self-employed businesses, because the deduction applies to the entire income earned from the business. It provides a smaller benefit to S-Corps, since S-Corp owners must be paid a salary and QBI does not apply to owners salary.
Pass-through income: when net income of a business "passes through" to the owner this means it is taxed to the owners on their personal income tax return. The business does not owe any income tax on these earnings.
The result is that while an S-Corp can substantially reduce social security and medicare tax, an S-Corp owner may pay more in income tax. An S-Corp also typically has higher expenses for payroll, accounting and tax preparation fees. The additional income tax and other costs may erode the tax savings entirely.
Making the decision
The best form of business is the one that suits your needs and works for you. The best choice is not the preference of your accountant or attorney, the one they most recommend to everyone else. Professionals are there to help you understand the options, not decide what your business should be or how to run it.
Unfortunately, some tax professionals may be motivated to encourage electing S-Corp status because they know the fees they charge you can increase by double or maybe triple. This is because an S-Corp requires an additional tax filing and the tax return is more complicated. The tax professional is correct to charge more, however, knowing this bias may exist can help you ensure you don't make a decision based on what is best for your accountant. In order to know if an S-Corp is right for you:
- Learn of all the form of business options. All options are good for someone, and none are bad. Having all the information will help you make a good decision.
- Get an analysis performed by a tax professional but do not settle for vague statements like "An S-Corp will be better for you." or "You will save a lot." Ask to see the actual numbers. Three numbers matter in this analysis:
- Payroll tax savings on S-Corp profit
- Additional income tax due to a lower QBI deduction
- Additional costs for payroll tax processing and tax preparation
- Compare all three numbers to determine your estimated tax savings, the changes needed to your administrative operations, and then consider if making the switch is going to be worth it to you.
For example, say you confirm that an S-Corp will save you $9,000 per year in payroll taxes. That sounds great. But if you will pay an additional $5,000 in income tax, and an additional $2,500 year in payroll and fees. Now your savings are down to $1,500.
With an S-Corp you have to follow additional rules for reimbursing the owner for expenses, need to do an owner reimbursement for home office deduction, health insurance premiums have to run through payroll and owners need to be more careful about how they keep their books and records. Further, if you are paid under a contract as an individual, such as from a university or hospital, the income cannot be assigned to the S-Corp. Only revenue earned by the S-Corp itself can be reported on the S-Corp return.
If after considering all these factors, you determine an S-Corp will benefit you and your business, then you can make the S-Corp election. Either an LLC or a C-Corp can elect S-Corp status. Read below to learn more about each form of business option.
Form of business options
There are five basic forms of for profit business entities.
Sole proprietor means no separate business entity has been formed, the owner and the business are one in the same. The owner may have a doing-business-as (DBA) name, also known as a fictitious name, established with the state or county, or may operate under the owners legal name. Although there is no separate business entity, it's still important to open a business bank account and have accounting records.
All income from a sole proprietor business passes through to the owner in the year it was earned.
- Owners pay income at the owners ordinary tax rate,
- Owners also pay self-employment tax of 15.3% on business net income. A deduction is provided for half of the self-employment tax, or 7.65%. This deduction of 1/2 of self-employment tax makes being self-employed comparable to an employer, as employers pay and deduct 1/2 payroll tax of 7.65%.
- All income from the sole proprietor business is potentially eligible for the QBI deduction, the owner may avoid income tax on up to 20% of business earnings.
- Taxes are filed on Schedule C with the individual tax return, no separate return is needed.
A sole proprietor is the simplest form of business. Little to nothing has to be done to set it up. It can be a great for a business you are operating by yourself. A sole proprietor may not be best if you are hiring employees, as there's no liability protection for wrongful action of employees.
Single-member Limited Liability Company (SMLLC)
Single-Member Limited Liability Company is a business entity established at the state level, and is separate from the owner. The U.S. federal government does not recognize the LLC and considers it a "disregarded entity." Which means sometimes the IRS treats the business as a sole proprietor. Because it is a separate entity, bank accounts need to be opened in the name of the LLC, not the owners personal name, and contracts and debts also need to be in the name of the LLC.
A Professional Limited Liability Company (PLLC) is a special type of LLC reserved for certain licensed professionals applicable in certain states. Check your state law to understand the rules for forming an LLC or PLLC. For example, in California most licensed professionals are unable to form an LLC. In other states a PLLC can be an option or may be required, the only option, for licensed professionals.
Income tax and self-employment tax for a single member LLC are identical to the sole proprietor listed above, and business income is also reported on Schedule C as part of the individual 1040 tax return.
A single member LLC is also a simple form of business, and similar to a sole proprietor except there is a legal business entity to provide some protection if the business defaults on debts. Many mistakenly believe that an LLC protects the owner from all lawsuits, which is not correct, but there is some protection for debts and wrongful action by employees. Obtain legal advice and speak with an insurance carrier to learn how you can protect yourself from lawsuits.
Partnership/Multi-Member LLC (MMLLC)
Partnership/Multi-Member LLC has more than one owner, with or without the LLC structure. Business bank accounts and credit cards are in the name of the partnership. A partnership agreement is required to show how the partnership operates and how profits and losses will be divided among the partners.
Partners pay Income tax and self-employment tax similar to a sole proprietor, however, profits and losses are divided according to the partnership agreement and taxes can be impacted by the agreement.
- The partnership has to file a separate tax return, Form 1065, each year by March 15th for the partnership. No tax is due with this return.
- After the 1065 is filed, each partner gets a Form K-1 showing their portion of profit or loss.
- The K-1's are used by each partner to report their profit or loss on their individual tax return. Partners pay income and self-employment tax on profits.
Partnerships can be complicated, especially when operations don't go as expected. Choose partners wisely. Expect higher legal costs to have the partnership agreement periodically reviewed and modified, including whenever tax laws change.
Entity taxed as an S-Corporation
Entity taxed as an S-Corporation means an LLC or a C-Corporation chose to elect to be taxed as a S-Corporation. This can happen if there are no more than 100 shareholders and certain other rules are met. If this election is made, owners that work in the business will be considered both owners and employees of the business and are expected to be paid a reasonable salary.
Because an S-Corp owner is an owner and an employee, they are taxed on the salary and the profit separately.
- Owners pay income and 7.65% payroll tax on the salary portion of their income. Owners get a W2 as any other employee. The S-Corp pays the other 7.65% of payroll tax. The S-Corp deducts the salary paid to the owner as a business expense, since owner will be paying the income tax on the salary separately.
- The S-Corp must file a 1120S tax form each year by March 15th showing the business profit or loss. The profit/loss represents the business revenue, less business expenses and owners salary. After the 1120S is filed, the owner(s) get K-1 forms showing their share of profit or loss.
- Owners include the K-1 form on their individual tax return. Income tax is calculated on the profit, less any QBI and other deductions. There is no self-employment or payroll tax on S-Corp profit.
The S-Corp return is more complex and so expect to pay double or triple the cost of tax preparation for an S-Corp return plus an individual return, compared to the individual return required for a self-employed owner. The owner will want to establish an accountable plan to be able to reimburse themselves for expenses without having to pay tax on the reimbursement. The owner cannot take the home office deduction on their personal taxes and instead must create an employee reimbursement for any home office expenses. Owners must be careful to only include revenue paid to the S-Corp in the accounting and tax records. Income earned by the owner as an individual cannot be assigned to the S-Corp.
C-Corporation is not a pass through entity. The C-Corp itself pays income tax each year on the profits of the business. Owners that work in the business are also employees and receive a salary via payroll and receive a W2 for those earnings. Profits can be held in the business for a period of time because they do not pass through to the owners automatically. When the Corporation declares a dividend, the profits are paid to the owners and the owner will pay tax on dividends in the year received. This is known as double taxation, because the Corporation paid tax on profits, and owners pay tax again when profits are distributed as dividends.
- A C-Corp pays corporate income tax each year
- The owner(s) who work activity in the business receive a W2 salary and pay income and 1/2 payroll tax on the salary. The C-Corp pays the other half of the payroll tax.
- Owner-employees do not pay tax on dividends until they are distributed, however, when the dividends are paid this is the second time they are taxed, as the C-Corp already paid tax on the profit in the year earned (double taxation).
- A separate tax return is filed for C-Corporation by March 15.
A C-Corp can offer more in the way of employee benefits to owners. Because S-Corps get special tax treatment, owner benefits can be limited. C-Corp owner-employees are treated more like regular employees when it comes to employee benefits. A C-Corp is one of the most complex business formations so explore carefully with an attorney and tax professional before forming a C-Corp. A C-Corp can elect to be taxed as an S-Corp.
A business may also be formed as a non-profit organization in which case you would not be the business owner. The non-profit is operated by a Board of Directors and management team. This option is not covered in this blog post. If you do want to form a non-profit, seek a tax and legal professional who are experienced in that area.
Self-employed vs. S-Corp example
To give you an idea of how the math works, let's use an example of a self-employed business, specialized service trade or business (SSTB), earning $125,000 after business deductions. The owner contributes $5,000 to a SEP IRA and files as a single individual. The owner also spends $5,200 for self-employed insurance premiums that can be deducted.
$125,000 business net income
$12,190 income tax (based on your tax bracket)
$17,662 self-employment tax (social security & medicare)
$29,852 total tax
23.8% effective tax rate
That number is huge. It's 24% effective tax rate, which isn't horrible but still a big number. Naturally you may want to reduce this tax. It's that large self-employment tax the tax accountant wants to help you avoid. Though, keep in mind that social security pays into a system that theoretically pays you back later.
Anywho, let's say you elect S-Corp status. You still earn $125,000, you set a reasonable salary of $75,000 and still contribute $5,000 to retirement plus pay $5,200 for insurance premiums, single filing status.
The S-Corp will be paying 1/2 the payroll tax and the other 1/2 comes out of the W2 salary. Rather than the business profit of $125,000, it will be reduced by additional costs and taxes the S-Corp pays for:
S-Corp business profit
$125,000 revenue less business expenses
-$75,000 W2 salary for owner
- $5,738 1/2 of payroll tax on salary
- $420 federal unemployment (plus may have state unemployment)
- $450 anual payroll processing fees
-$1,000 additional tax preparation cost
$42,392 business profit
The owner will be taxed on the $75,000 W2 income plus the $42,392 business profit. So let's see how this differs from the self-employment taxes above.
S-Corp owner's taxes
$75,000 W2 income
$42,392 business profit
$117,392 total income
$15,190 income tax
12.9% effective tax rate
This number is significantly lower and is only 13% effective tax rate. The income tax is higher ($15,190 compared to $12,190 for self-employed) due to several reasons including that the QBI deduction is lower (QBI deduction is only applied to $75,000 W2 salary and not the $125,000 total business income).
There is no payroll tax ON the tax return, because half was paid by the S-Corp and 1/2 came out of the W2 paycheck.
Who would not jump at the chance to pay $14,662 LESS to the government each year? If your tax accountant said you would save this much you would probably ask, "Where do I sign up?" and "Why didn't you tell me about this sooner?" But before you do, consider the costs that will not be apparent when looking at the tax return:
Total S-Corp taxes on the 1040 return & paid elsewhere
$15,190 income tax on 1040
+$5,738 payroll tax paid by S-Corp (comes out of owners profit)
+$5,738 employee payroll tax (deducted from owners W2 salary)
+ $420 federal unemployment tax (not owed for self-employed)
+ $450 payroll processing fees (since owner has to be on salary)
+$1,000 extra tax prep costs (because complicated S-Corp returns cost more)
$28,536 total personal tax + additional S-Corp tax + fees
22.8% effective tax rate considering ALL taxes paid
Now we are at 1% effective tax rate savings. The actual savings are $1,316 per year when all taxes and costs are considered. That's just over $100/mo. That tax savings isn't much given you will spend extra time running payroll, will need an accountable plan to reimburse yourself for expenses, cannot take the home office deduction on your taxes because it will need to be a formal reimbursement instead, and you will need to file an extra tax return each March.
Furthermore, in retirement your social security benefits will be based on the $75,000 salary not the $125,000 total income as it would be for a self-employed owner. You will receive lower payments since social security uses the the top 35 years earnings to calculate benefits, and every year the social security earnings will be lower. Lower social security is fine if you have a significant tax savings to invest in retirement. Not so great if the tax savings are small.
If your accountant does this FULL analysis and comes up with there still being substantial savings, then go for it! I would totally jump on saving tons of tax if I was really, truly going to save what was suggested. I would absolutely avoid making a decision on incomplete information and analysis. Use the guide above to make sure the analysis considers all the tax and fees the S-Corp will pay.
You may wonder if you can do your own tax savings analysis. The answer is yes, you just need a tool. Accountants create their own analysis tools which may or may not represent a complete analysis. Simple Profit has a comprehensive spreadsheet tool that you can access and complete your own analysis using the prior year tax return and the current year income estimate. It is available in the Simple Profit membership.
A tax accountant can increase S-Corp tax savings by making the owners salary unreasonable low. Sometimes it is set ridiculously low. Two issues to be keenly aware of in this scenario. One is that the IRS knows owners can save by setting the salary too low. They can see salary on the S-Corp return and if they audit an owner and find a low salary, they can re-characterize some distributions as salary and charge additional tax, interest and penalties. Two is that the lower the salary, the lower the social security benefits in retirement. You want to be aware of that going in and not surprised by it 20 or 30 years from now.
What if I'm already an S-Corp?
The S-Corp does save some business owners substantially. But even if not, there may be no compelling reason to switch back to a different form of business. The current tax landscape may neither give a compelling reason to choose S-Corp, nor a compelling reason to undo it. If you are curious how much an S-Corp is saving you now, you can always ask your tax professional to calculate what it would cost to be taxed another way, and do a comparison, factoring in payroll tax savings, impact of the QBI deduction on income tax, and additional tax prep and payroll fees.
Here are some additional resources that may be helpful as you make your form of business decision.
To learn how business owners pay themselves from the various forms of business, watch this video: https://youtu.be/hEE6f4Y2yQc
Corp owner salary
S-Corp and C-Corp owners must pay themselves a reasonable salary for work they perform for the business, if there is income available to pay the owner. This video explains how to set a reasonable salary and includes a free handout to use: https://youtu.be/7jotL9-APRo
LLC limited liability
There are myths about the legal protection an LLC can provide. It does not protect us from our own wrong doing. We do need various types of insurance for our business so that we can be protected if we are sued. This legal article explains the actual protection an LLC will and will not provide: https://www.nolo.com/legal-encyclopedia/limited-liability-protection-llcs-a-50-state-guide.html
If you have employees or you are an owner-employee of your S-Corp or C-Corp, it is important to establish an accountable plan for employee reimbursement. This ensures that your own and our employee reimbursements will not be taxed. Self-employed owners do not need this to be able to reimburse themselves tax-free: https://www.journalofaccountancy.com/issues/2020/feb/employee-expenses-accountable-plan.html
Starting your business: If you are just starting your business, these 10 essential steps will help you get started: https://www.simpleprofit.com/start
It can be overwhelming to choose your form of business. Making an investment upfront to learn your options and make a careful choice can save you the headache of having to switch your form of business later.Avoid choosing because someone else said it was best, unless you fully understand and agree it's the best choice. Makes some appointments to consult with professionals and discuss until you are confident you are making the best choice for you.
The Simple Profit membership provides support to business owners. Get the education and resources you need to make informed business decisions and establish quality business processes, including bookkeeping and cash management tasks.
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