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Business Entity Selection
Posted Tue, June 2, 2020
Choosing a business entity type should not be that troubling although many new business owners tend to fret over it. We understand why! We do! There is a ton of information out there, and between talking to your produce clerk and your buddy down the street, there can be more questions than answers. At WCG, we tend to keep things simple. Yes, we’ll complicate the heck out of stuff if it makes sense to do so and if it will meet certain objectives. As such, in the interest of simplicity, here we go-
- LLC is your first choice. Simple. Easy. Tax efficient.
- Corporation is your next choice. Unpopular and tax inefficient, but there might be reasons why you need one (keep income off 1040, California, venture capitalist).
- Professional LLC (PLLC) or Professional Corporation (PC) if you are an accountant, attorney, medical doctor or engineer.
See! Simple. Let’s look at a fun table, shall we?
|Formation||Articles of Formation||Articles of Incorporation||NA|
|Internal Governance||Operating Agreement||Bylaws, Shareholder Agreement||Depends|
|Owners Called||Members||Shareholders||Depends (Shareholders)|
|Owners Take||Owner Draws||Dividends||Shareholder Distributions|
|Federal Tax Rate||15.3% + Individual Tax Rate||21% + Dividend Tax Rate||Payroll Tax + Individual Tax Rate|
Under S Corp, the “depends” is double-talk that we accountants love to use for everything. However, in this case it is quite simple. Since an S corporation is only a tax election, nothing changes from an internal governance and ownership perspective. If you have an LLC taxed as an S Corp, then you will have an Operating Agreement and you will own an interest. If you have a corporation taxed as an S Corp, then you will have Bylaws (and perhaps a Shareholder Agreement) and you will own shares. However, in accounting parlance, we will commonly refer to owners of an LLC taxed as an S corporation as shareholders from a tax return perspective but they are truly members.
The 15.3% under LLC represents self-employment taxes which are the same as Social Security and Medicare taxes.
Corporations remain tax inefficient and S Corps remain a good tool for overall tax efficiency. We’ll discuss further in a bit.
Not too long ago we said that the primary choice is an LLC. However, let’s define that selection in the negative. In order words, let’s see if a corporation makes sense first… and if not… the negative… will default to our class favorite, the limited liability company.
We have a video on C Corps which goes through a lot of this, including a PowerBore slide deck. Here we go-
C Corporation Problems
C corporations remain tax inefficient. The primary motivation is the seemingly sexy 21% tax rate for C corporations and while this might be lower than some taxpayer’s marginal rate, this is a sucker hole for business owners for two painfully obvious reasons. First, your marginal rate might be 24% or 26%, but your effective tax rate (or blended tax rate) is much lower. We’ll show you… not to worry.
Second, there is a little thing called double taxation where the C corporation pays a tax and then the shareholders pay a dividend tax on the money that is distributed. And… if you think you’re a smarty pants and say, “Yeah, but, I’ll just keep all my money in the C corporation for a rainy day and lower tax rates,” there is another little thing called accumulated earnings tax.
Let’s illustrate this with some good old fashioned devils buried deep into the details. Assumptions include-
- Section 199A deduction for the S corporation’s shareholder
- $24,000 in standard deduction
- 3.8% surtax on top of the 15% capital gains tax rate for the $300,000 column
Buckle up buttercup ’cause here we go-
|S Corp Income||100,000||200,000||300,000|
|Total Tax S Corp||13,100||36,390||62,626|
|C Corp Income||100,000||200,000||300,000|
|C Corp Tax||21,000||42,000||63,000|
|Total C Corp Tax||21,000||65,700||107,556|
|Effective S Tax Rate||13.1%||18.2%||20.9%|
|Effective C Tax Rate||21.0%||32.9%||35.9%|
|Delta (extra tax because of C Corp)||7.9%||14.7%||15.0%|
As you can see, a C Corp does not make sense after you add in capital gains tax on the dividends. This in turn makes sense- the lawmakers didn’t set out to kill S corporations. They set out to give every business owner a tax break. Geez… half of Congress (535 doesn’t divide evenly, we get it) probably run S corporations on the side for their consulting and speaking gigs. C Corps remain a bad idea for tax efficiency.
Also note the effective tax rate (or labeled as tax “pain”) for the S corporation owner. At $100,000 in net business income, the total tax pain including payroll taxes is 13.1%, and at $200,000 it is only 18.2%. This is still well below the C corporation tax rate of 21%.
And! There’s more! C corporations do not enjoy the 20% Section 199A deduction either. Pile that onto the numbers above for even more reasons.
So, please pump the brakes on the “I wanna dump my S Corp for the magical tax arbitrage offered by a C Corp” nonsense. Wow, that was harsh. We did tell you to buckle up but then we offended you by calling you buttercup. Safety with an insult.
C Corporation Benefits
Corporations are not all bad. Here are some benefits-
Keep Income Off 1040
One of the benefits is you keep income off your individual tax return (Form 1040). For example, if you had an LLC whose business transactions were typically reported on Schedule C of Form 1040, if you converted this LLC to a corporation, the income is contained in the corporate tax return (Form 1120). If you pay a salary or pay out dividends, that changes things. Why would you want to keep income off your individual tax return? Perhaps you have Social Security or disability benefits that might disappear or become taxable. Perhaps you are running away from some bad guys who are collecting on a debt. Perhaps you use the C Corp to pay for your mistress of her expensive tastes. All kinds of reasons!
As mentioned elsewhere, the golden rule is: the person with the gold makes the rules. So, if you are looking for an investor to kickstart your heart like Nikki Sixx, and the only way it happens is if you create a C corporation, then that is what you do. All kidding aside, venture capitalists, angel investors, and all the other silly things people call themselves, like corporations as opposed to LLCs.
Having your employees own member interest in an LLC can be tricky since each one would get a K-1 regardless if their interest was economic only (profits) or equity (ownership). You could get around this by having your employees own the right to a portion of the business which triggers into equity upon a certain event such as transfer of ownership or control. In other words, Employee A has the right to 2% ownership upon sale, partial or wholesale. This works! But… it can also be messy and hard to explain. WCG converted to a C corporation for this reason; we are selling bits and pieces of our business to partners and employees, and shares in a corporation makes more sense. Each partner is paid a fee for service directly from the corporation.
This is akin to a barrel of oil… you can either own the right to the barrel of oil, or the barrel of oil itself.
California (and others)
If you are a professional such as attorney, accountant, medical doctor or engineer, you typically have to register as a professional entity, either a Professional LLC (PLLC) or a Professional Corporation (PC). However, some states, such as California, does not recognize PLLC and as such you must create a corporate that is deemed to be a PC. And in those cases, we typically recommend an immediate S corporation election to have your PC taxed as an S Corp (see crummy C Corp tax rates above).
Colorado and Texas, among several other states, allow for a PLLC or a PC… up to you. WCG is a PC.
Who wants to pick on California some more? We do.
State Disability Insurance
California allows corporate officers to opt-out of State Disability Insurance (SDI). SDI is California’s version of FMLA, and some business owners want to go on leave for new babies, etc. However, if your baby-making days are clearly in the rearview mirror, then perhaps you want to opt-out of SDI. This is easily done, but only for corporate officers… and No, members of an LLC are not considered corporate officers since LLCs are companies not corporations. All in all, WCG creates far more corporations in California for this reason and for the PC designation reason.
If your estate plan attorney or another attorney recommends a corporation, ask the hard questions so you understand why. There might be good reasons to do so… and we leave room for attorneys to be right some of the time.
In summary, like a nauseating college paper that you know for darn well your professor will only skim in between martini sips, unless you fit the buckets above, then you should be an LLC.
Limited Liability Company Entity
Okay, so your business and objectives don’t readily fit into the C Corp bucket above, then you are probably looking at an LLC. Just like corporations, we have a video on LLCs which goes through a lot of this, including a PowerBore slide deck. Here we go-
While a single-member LLC is considered a disregard entity by the IRS, the states are not so accommodating. For example, California wants all LLCs to file Form 568 to a franchise tax and LLC fee can be computed. New York is similar. Texas has a franchise tax which starts at $1 million in gross receipts, but you still need to file a franchise tax return regardless.
We would be remiss if we didn’t mention self-employment taxes. Recall that as a garden-variety LLC without an S Corp election, you pay two types of taxes… self-employment taxes (which is synonymous with Social Security and Medicare taxes) of 15.3% and income taxes at your individual tax rate. You could easily pay 15.3% + 22% = 37.3% in taxes on net business income after expenses.
LLC formation is public record, and normally business owners use their home address for filing purposes. Some states allow for anonymity at the LLC level while most states protect identities of corporate owners who might be different than the “incorporators.”
There are a handful of LLC benefits as well. LLCs are easy to launch, and most states draft the Articles of Formation directly online. LLCs also offer some liability protection for contractual obligations and other financial obligations (no, they do not categorically protect you from tort liability).
LLCs also allow you to obtain an EIN which in turn allows you to open a business checking account. This compartmentalizes your business life from your personal life. Arguably, you could forego the LLC and simply open another personal checking account to compartmentalize your worlds… but the LLC way is more elegant.
Lastly, an LLC has interest, either economic (such as profits) or equity (ownership). Interest can be sold or transferred, in part or in whole. This continuity or portability feature might not be necessary today, but at some point you’ll exit your business… by choice or by nature.
Avoid Self-Employment Taxes
A common complaint from those who own their own business is self-employment tax. Can you avoid, reduce, eliminate or lower your self employment taxes or SE taxes? Yes, to a large extent actually, but it takes some effort (like a tiny tiny amount) and an S Corp Election.
If you own a business as a garden variety single-member LLC (one owner), your business income will be reported on your personal tax return under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. The same is true for a business that has not formed a corporation such as a sole proprietor and partnerships. So, you could easily pay an average of 40% (15.3% in SE taxes + 25% in income taxes, blended) on all your net business income in federal and state taxes. Perhaps more… Wow!
Income taxes is largely a sunk cost. You can reduce it by having less revenue, spending more money on deductible things and / or earning some of the various business tax credits.
If you own an LLC and have elected to be treated as an S corporation for taxation, the business now files a corporate tax return on Form 1120S. What’s the big deal? Before we get into that, let’s look at some quick numbers. These are based on using a salary of 40% of net business income for incomes up to $500,000 and then decreased incrementally to 30% for the millionaire at $2,500,000 below (real case actually)-
|Income||Total SE Tax||Salary||Total PR Tax||Delta||Delta%|
Don’t get too hung up on the drop in percentages. Focus on the overall hard dollar amount. Notice the sweet spot at $100,000 to $150,000 (yes, it dips at $300k due to Social Security limits). Also consider that if you run self-employed health insurance through the business (and you should), savings jumps up even more. Why? It has to do with the Social Security wage limit ($137,700 for the 2020 tax year) and we expand on this in our book titled Taxpayer’s Comprehensive Guide to LLCs and S Corps.
Bottom line savings is about 8-10% of your net business income after expenses for those earning $100,000. So, if you make $100,000 after expenses you’ll save about $8,000 to $10,000 in overall taxes, and they are all self-employment taxes. Self-employment taxes = Social Security / Medicare taxes = payroll taxes. All the same thing (in general). This is 8-10% number is just a jumping off point; as the table above shows, the percentage of savings goes down as income increases but the overall savings continues to rise, and can also increase to 12% to 15% depending on self-employed health insurance premiums and HSA contributions.
There is a cost to being an S corporation of course- all that glitters is only partially gold. Additional tax preparation fees for the corporate tax return and payroll processing are the two biggies. Still not convinced? No problem… please check out Line 4 from Schedule 2 on your Form 1040 tax return. This number reflects the self-employment taxes paid on your business income. We want to reduce this by 60 to 65% and we assume you do too!
Check out these S Corp resources as well-
Please visit the following buttons for additional resources such as business structure and formation, business support services and business entity tax preparation.
LLCs and S Corps Book
Shameless self-promotion alert! We have written a dorky book called Taxpayer’s Comprehensive Guide to LLCs and S Corps. Over 300 pages of pure pleasure. It is available online, for free, within our KB articles, or from Amazon and other less than average retailers. Please click on the button below for more information-
How does business formation work? When should you do it? When should you delay it? Let’s chat!
WCG is a tax and business consulting firm in Colorado Springs, Colorado but we serve clients all over the world… primarily in California, Texas and the east coast which coincidentally is where the nation’s GDP is generated.