Entity type selection isn’t as cut and dry as many aspiring business owners may initially think. Because double taxation and ownership restrictions are inherent in other entity types, many business owners have turned to the liability protection offered by forming an LLC. For your business to effectively decrease taxes, limit liability, and maximize profits, you need to perform a thorough evaluation of each entity structure based on your business’s specific circumstances. An LLC is not always the right choice of entity. You may be limiting yourself and your business.
In the not-so-distant past, entity type selection for a new business came down to a choice between a corporation or a partnership. The first limited liability company (LLC) didn’t come about until 1977 in Wyoming. And, for many years to follow, LLCs remained an unpopular choice. According to the IRS’s data, around 2.5 million returns were filed for LLCs in 2015. What changed that made it such a popular choice, the one new business owners and their attorneys often default to when setting up a new business? In 1988, the IRS ruled LLCs with two or more members would be taxed as partnerships, while those with one member would be treated as a disregarded entity. Other states followed suit, enacting LLC statutes of their own.
LLC Owners Are Subject to Self-Employment Tax
As an LLC owner, you are not permitted to pay yourself W-2 wages, nor can you deduct the wages paid to yourself. A single-member LLC operating a trade or business is subject to the tax on net earnings from self-employment. The self-employment tax rate for business owners is 15.3% of net income up to an annual threshold and 2.9% for income beyond the threshold.
For multi-owner LLCs, each active owner pays taxes on their share of the profits on their personal income tax returns. And each member must pay taxes on his or her whole distributive share each year, even if the LLC doesn’t actually distribute any or all of the money to the members. LLC owners pay twice as much self-employment tax as regular employees because employers match regular employee contributions to the self-employment tax. LLC owners may deduct half of the total amount paid in matching employee contributions from their taxable income.
Setting up owner salaries and estimated tax payments when your entity type selection is a C or an S corporation is generally a little easier. While LLCs are not able to take the Section 199A deduction based on owner-guaranteed payments, S Corporations can take advantage of the deduction based on owner salaries. Flow-through income from an S corporation is not subject to self-employment taxes, and taxes on C corporation profits occur at the entity level at a flat rate. If you’re already an LLC, keep in mind that you can elect to be taxed differently. When taxed as a sole proprietorship, partnership, or S corporation, the income passes directly to owners. Each owner owes taxes at his or her personal income tax rate on his or her share of the profits. Making an “S” election as an LLC is more straightforward than incorporating.
C Corporations Are Provided Certain Benefits
The Tax Cuts & Jobs Act (TCJA) reduced the top corporate income tax rate from 35% to 21%. The legislation also repealed the corporate alternative minimum tax, reduced the percentage of the dividends received deduction from 70% to 50%, and loosened the restrictions on the use of the cash method of accounting.
C corporation profits are taxed to the corporation when earned and to the shareholders when distributed as dividends. In select circumstances, the double tax still won’t affect net income as much as it would for a sole proprietor or individual in the top tax bracket, so it’s worth a thorough assessment. Retained earnings are not double taxed, meaning you might benefit from electing corporate taxation if you regularly keep a substantial amount of retained earnings. The tax treatment of fringe benefits for owners is also favorable for C corporations.
IRC Section 1202 created the “qualified small business stock” (QSBS) tax exemption, which exempts the capital gains from qualified small businesses from federal taxes. Section 1202(a) also allows a stockholder the potential to exclude up to 100% of the U.S. federal capital gains tax incurred when selling the stockholder’s stake in the start-up or small business.
Transfer of LLC Ownership May Be Challenging
Transfer of LLC ownership must occur in accordance with the LLC’s operating agreement, agreed upon by all owners, and it must be allowed in the state in which the LLC was created. Transfer of ownership for a S and C corporations can be a relatively simple process unless the bylaws of the corporation provide a restrictive right.
The decisions you make about your company in the early days are critical for your future success, including entity type selection, tax planning and compliance strategies, and planning for your exit. I work with business owners of all types to grow from start-up to successful exit. Contact me today to learn more.
Larry Andler is a Partner at LGA and has over 25 years of experience working with individuals and companies of all sizes in a variety of industries. He focuses on high net worth individuals with complex reporting challenges and their related businesses and trusts, startups, and C corporations.