Are you maximizing your business tax deductions?
Most businesses begin as a sole proprietorship only because it is easier to start and requires less paperwork and regulatory overhead, and therefore generally costs less than filing as a Limited Liability Company (LLC) or Incorporation (INC).
However, each has certain tax strategy advantages so it is important to carefully consider which status is the:
- Best legal structure for your business goals, and
- Most tax beneficial that keeps more money in your pocket annually.
You can also elect either entity to be treated as an S-Corp to save your business from paying more money to the IRS.
For those choosing either the LLC or INC entity structure, an S Corp status allows the business to use “pass-through taxation” (i.e., business income goes directly to owners instead of the corporation) to potentially save money, instead of the LLC’s profits being subject to payroll taxes, or an INC’s profits being taxed at the C-Corporation tax level and then subject to payroll taxes and taxable dividends when distributing the money out.
Brief Overview of an INC Structure
INC status offers business owners (i.e., shareholders) the strongest protection from business liabilities as it is a separate legal entity from the owners and shareholders.
Keep in mind that when initially setting up an INC the IRS automatically treats the entity as a C-Corp and therefore all profits and losses flow to the corporation, where taxes are paid at C-Corp tax rates. While business expenses, retirement plan costs, and even employee benefits can be deducted by the corporation, the only way to extract money for a shareholder/business owner with a C-Corp is to pay themselves dividends or W2 salary.
The dividends paid out to the shareholders, however, as well as W2 income paid to the shareholder/owner, is taxable income on an individual’s 1040. This is what is meant by “double taxation,” as the most common way for an owner to extract money from a C-Corp tax structure is to pay themselves dividends (taxed as individual dividend rates + Net Investment Income Tax) and pay themselves as a W2 employee paying payroll taxes on all of your W2 salaries.
But what if you elected S-Corp status for your INC? You’d be able to just pay payroll taxes on a “reasonable” W2 salary and the rest would be taxed at your individual effective tax rate.
Brief Overview of an LLC Structure
A Limited Liability Company (LLC) is the most common alternative to the INC. The business structure of an LLC has more flexibility than an INC, is easier to maintain without the required annual meetings and minutes, and still provides a good deal of protection from legal liability as long as you separate business and personal expenses from the LLC accounting and operations.
LLCs are generally classified as pass-through entities and any profits and losses are passed through to the members of the LLC and claimed on the member’s personal tax returns unless the LLC members elect to have the company taxed as a C-Corp where profits are taxed at the corporate tax rate.
How can electing S-Corp Status with the IRS benefit me?
Becoming an S Corp is done strictly for tax purposes. A business stays the same legal structure of an INC or LLC status, but by electing S Corp status the business can elect to have their profits and losses pass-through to their individual 1040 tax return to potentially save on paying more taxes than necessary.
The main reason for choosing to elect S-Corp tax status is to avoid paying payroll taxes on all of your profits and avoid double-taxation. Instead, an S-Corp election allows for business owners to pay themselves a “reasonable” salary, and only pay payroll taxes (Social Security, Medicare, Federal Unemployment, and State Unemployment tax) on the salary.
Is electing S-Corp Status the right choice for my business?
While all S-Corps profits and losses are passed through to an individual’s 1040, it is not beneficial to all businesses. For startups looking to take on equity investment, businesses looking to offer equity compensation, or partnerships looking to split profit/loss and equity interests an S-Corp election would not be the right choice.
In order to maintain an S-Corp tax election, the business must be a U.S. LLC or INC with only one class of stock and less than 100 shareholders. All shareholders must be individuals, estates, or specifically qualified trusts. Each shareholder must consent in writing to the S Corp election and must be a U.S. Citizen or permanent resident alien with a U.S. Social Security number. Finally, the tax year for an S Corp must end on December 31.
You can also update your tax election with the IRS at any time by a majority shareholder vote. There may be tax consequences for doing so. Lastly, note that given the 199A (Qualified Business Income Deduction) deduction, electing S-Corp status becomes potentially more beneficial to maximizing your tax savings depending on your industry.
If you’re considering changing your business entity status or starting a new business altogether, reach out to us to help you register the appropriate business entity for your needs.