by Neil Jesani
To illustrate how this works, let’s look at the numbers for 2019. The FICA tax breaks down so that the employer and employee each pay 6.2% of a person’s wages or salary into Social Security. Once a person hits $132,900 in earnings, he or she stops paying for the Social Security piece until January 1, when the new year begins. For Medicare, the rate is 1.45% for both employee and employer, and that continues no matter what a person makes. That means up to the time someone makes $132,900, that person is paying 7.65% of their income into FICA. This money comes right off the top and you have no deductions or recourse to get any of it back. If the government runs it correctly, you will see some of it when you retire! Now if you are self-employed, you pay the combined employee and employer amount, which is a 12.4% Social Security tax on up to $132,900 of your net earnings and a 2.9% Medicare tax on your entire net earnings. If your earned income is more than $200,000 ($250,000 for married couples filing jointly), you must pay 0.9% more in Medicare taxes.
Now the purpose of this book is not to overwhelm you with the fact that we all pay a great deal of what we make into taxes. Truthfully, if you dwell on that fact every morning, the tendency is to cover up under the blankets and not get out of bed. This does not even touch on the other taxes you have in life such as property taxes, sales and excise taxes, estate and gift taxes
What we are going to look at in-depth for the rest of this book is how to save money on one of your biggest payments – the income tax that you send to the various governments. The tax laws are full of loopholes and nuances that are almost impossible to keep track of. For one thing, they are constantly changing, as we have seen in the Tax Cuts and Jobs Act of 2017. The other factor is that many aspects of the tax code only affect certain individuals or income levels. So it is important to know how you fit into the maze of codes, regulations and statutes.
There is a variety of ways to take large deductions when you own your own business and make a substantial income. These greatly reduce your annual tax burden. Besides making an immediate impact on what you pay the federal government each year, you will be hanging onto more of your money so that it will be there when you are ready to retire or move on from what you do now. Like so many strategies in our personal finances, one size doesn’t fit all. We will look at a variety of programs that you can weigh against your own personal situation. Here is one last word on financial professionals. Not everyone knows everything. This is true in all walks of life and you have to take the time to know the background of the person you’re working with. For example, Certified Public Accountants are fantastic at making sure your books are correct, and that all the proper filing is done for taxes and other financial matters. While their knowledge is broad, please do not assume that they are familiar with everything that can benefit you in terms of saving on your taxes. They certainly know how to keep an accurate accounting of your income, savings, and deductions, but they do not have the time or training to know the intricacies of all the programs available to you.
The same is true of tax attorneys. They certainly should know the pertinent laws, but they are not experts on investment-based tax strategies unless they have taken the necessary training. One area that many people err in is taking advice from the wrong — or less than competent — professional. Your finances are going to be complex, and many times you are asking questions as different as apples and oranges. Make sure the professional you talk to is well versed in apples if you are asking an apple question and the same for the oranges!
Ideally, you want to put a good team together to navigate the cross currents of your personal finances. When running your own business, or when reaching a certain income threshold, you are going to need a CPA to make sure your accounts and paperwork are correct. Depending on the complexity of your business and/or estate, you might want a tax or estate attorney for the necessary help. For figuring out how to invest and receive the most potential tax savings right now and for the future, talk to a certified financial planner with the specialized training, experience, and a track record of successfully helping others in a similar situation.
As we have seen from this introductory chapter, people pay a great deal of money to the government. It is bad enough when you work for a company and your employer has the responsibility of taking the necessary deductions out of your paycheck. However, if you own your own business, the responsibility to make sure your taxes are up to snuff falls squarely on your shoulders. As you read the rest of this book, we are going to look at the options you have to make this process as simple as possible. More importantly, we are going to see how you can keep significantly more of what you own, rather than handing it over to the United States government.
CHAPTER 2
Taxation of Various Business Structures
“For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.”
Winston Churchill
W
hen you are establishing your own business, there are many things to consider. It is important to put together as thorough a business plan as possible. Ideally, you should do this even before you sell your first item, see your first client, or treat your first patient. The reality is that this isn’t always the case and many business owners practically have to reboot their business to align it in a manner that allows them to operate at an optimal level. It is okay to do this if you are already up and running. Sometimes a new business owner needs to get some experience under his or her belt to realize the areas they need to improve in order to strengthen their operations, cash flow, and income.
While a great business plan consists of many components, we’re going to focus our attention on the ones affecting how your income is taxed. Often when somebody starts out in business, they do not anticipate the issues they will face as the company becomes bigger and more money pours into the business coffers. If you are just starting out establishing your own company, think about how you want to set your business up. However, if you have been operating already, it is perfectly fine to make changes if you believe that it is going to be advantageous for you.
One of the biggest questions facing most business owners is deciding what form of corporation will fit their needs best. This is an important consideration because how you establish your business determines how the Internal Revenue Service taxes your income. In fact, the IRS is one of the government entities you have to file with when you are starting out.
Many first-time business owners start out their companies as a sole proprietorship. Sometimes people do this because they really aren’t sure where their business is headed. It might be something a person only wants to do part-time, or it is a start-up with no clear vision of success. It is also the easiest one to establish in terms of paperwork. All you have to do is send a form into the IRS requesting an Employer Identification Number (EIN) and you’ve created your own company. Depending where you live, there may be other things you need to do, such as registering the name of your company or filing local paperwork. For the most part, once you have that EIN, you are good to go.
Taxation as a sole proprietor is very straightforward. All of your net proceeds are taxed as individual income. The negative aspect of sole proprietorship is that you are exposing your personal assets to business liabilities. Nowadays, it is very easy to create and maintain a corporation, and often it is a mistake not to incorporate.
Let’s look at several options you have when deciding what type of business structure you want to adopt. Generally speaking, there are three main choices when deciding on the ideal structure for your company. As we will see, they all have their pros and cons. Here is a broad picture of each of them, including the tax considerations.
S Corporation
First, we will look at an “S corporation.” This is a typical corporation with a special tax designation by the IRS. As with any corporation, an owner files the necessary paperwork with the state along with all the appropriate fees. All states have websites to get the particular doc
umentation for corporations established within their borders. Most states have departments to help guide businesses through the maze of paperwork and fees to become established.
Let’s look at the tax considerations of an S corporation first. It is a standard corporation that has elected a special tax status with the IRS. Unlike a C corporation, which we will talk about next, an S corporation (S corp) does not pay any tax at the corporate level. What happens is that the profits of the company (or losses) are passed through to the shareholders. They in turn report this income or loss on their individual tax returns. For any tax that needs to be paid, it is done according to the individual’s rates.
An S corporation is something to consider if you want the advantages of a corporation, but do not want to worry about dealing with a corporate tax and the income tax. One of the biggest reasons for incorporating your business is the limiting of your liability. By having your company under the auspices of a corporation, if a patient, client or customer sues you, then your personal property and savings are protected.
It is important to keep in mind that forming a corporation for your business will not protect you from professional errors. For example, if you are a doctor and a patient comes in to your office, slips on the floor, and injures his or herself in the fall, you have liability protection. However, if you do not treat a patient properly and he or she has future complications, your corporation will not protect you. This is no small consideration in our lawsuit happy world. This is a component of incorporating no matter which form you choose.
There are also other benefits with forming an S corporation. It provides alternatives to set salaries for the owners and employees, which helps you minimize the FICA tax. There also are accounting considerations. Most corporations must use the accrual accounting method unless they are considered a small corporation, which means the company has less than $5 million in annual gross receipts. Most S corporations fall into this area and do not use the accrual method unless they are a business that carries inventory. The reason this can be important is that accrual accounting can be a bit complex and can cost more to maintain.
Statistically, an S corporation has a lower chance of an IRS audit. S corporations file something called the informational tax return (Form 1120 S U.S. Income Tax Return for an S Corporation). Apparently, the IRS audits more companies when business income is only reported on Schedule C of Form 1040 on an individual’s tax return.
In terms of the structure of an S corporation, it can have no more than 100 shareholders. Those shareholders have to be United States citizens and residents. Furthermore, a corporation, partnership, or trust cannot own an S corporation. There is only one class of stock and all shareholders must agree in writing to accepting the S corporation designation.
To summarize the S corporation, it avoids the double taxation of the corporate tax and allows the pass-through of profits and losses. Because the initial years of establishing a business have many start-up expenses that become tax losses, many businesses start out as an S corp, and may decide to change to a C corporation down the road. We’ll talk more about C corporations in a moment.
One of the downsides to an S corporation is if the owners (stockholders) are in a high-income bracket, then their share of profits will be taxed at that high rate. While we will be looking at how to reduce that tax burden throughout this book, it is a consideration to keep in mind.
One other negative to an S corporation occurs when you are a high net-worth individual and doing your estate planning. If, later in life, you create a trust during the estate planning process to hold your company, S corporations are ineligible to be owned by a trust.
In summary, if you think your business should incorporate as an S corporation the main components you need to consider include:
1. It has to be a domestic corporation (headquartered in the United States).
2. Have no more than one hundred shareholders (none can be nonresident aliens, corporations, or trusts).
3. All shareholders consent to becoming an S corp.
4. Have one class of stock.
5. File the necessary paperwork with the IRS (Form 2553) and be approved by the IRS.
C Corporation
Now, a C corporation is more like what most of us think of as the standard corporation. Like the S corp, you file the necessary documents and pay the filing fee with a state to form a C corporation. The framework of a C corporation dictates that the personal liability for the corporation’s business debts is limited to how much money each shareholder puts into the company.
One of the biggest differences between an S and C corporation is in the area of taxation. The C corporation or C corp is considered its own entity and thus has to file a corporate tax return to report its losses or profits. If there are profits, they are then taxed at the current corporate level (approximately 21% in 2019). Losses do not pass through to the shareholders to use as a deduction against other income. In fact, the profits of the C corporation can be “double taxed.” Besides the corporate tax on profits, any dividends passed onto shareholders are reportable income and the individuals have to pay taxes on them at whatever their current rate is. In other words, the profits are taxed at the corporate level and again on the individual’s tax return.
Besides the double taxation by the federal government, many states also have an income tax that only applies to C corporations and applies to all income over a certain amount. In many cases, that means profits from a C corp are taxed three times – twice by the feds and once by the state. Throw in states with their own personal income tax, and those dividends received by a stockholder, may be skimmed for the fourth time.
All that said, there are many reasons a C corporation might be the right way for a company to go. The C corporation has fewer restrictions in terms of its establishment than an S corp. For one thing, it can have an unlimited number of shareholders. Those shareholders can be from outside the United States as well as being other corporations, partnerships, or trusts. Because of this, it puts the company in a better position to raise venture capital for funding or to take the company public. You can have several classes of stock in a C corporation as opposed to only one with an S corp, and the C corporation gives different profit-sharing options to its stockholders. This enables more profits to stay within the company to foster growth.
In terms of tax planning, you can see how a C corporation can spread the earnings between the company and shareholders. Like the S corporation, a C corp gives greater flexibility over structuring salaries and benefits for the owners and the employees. It is also simpler to set up expense accounts for travel and entertainment as well as offering stock options to employees.
Some of the downsides with a C corporation are that it must file a tax return every year with the IRS. This has to be done even if the company had no income. The additional tax filings and complex bookkeeping means more accounting work in a C corp. As mentioned earlier, some states have a state corporate income tax. Corporations with employees are required to pay federal (and sometimes state) payroll and unemployment taxes.
Here is one last note on the C and S corporations. All corporations are C corporations unless they specifically elect to become S corporations.
Limited Liability Company (LLC)
An LLC is a type of a business structure that combines the best of the S and C corporation. It is a way of organizing your company so that a business owner (or owners) can limit their liability while maintaining pass-through. An LLC is not subject to a corporate tax, and an owner’s personal savings and property are protected. In terms of income tax, the profits and losses of an LLC pass through to the owners and are then paid on their individual income taxes.
An LLC is formed by the proper filing of documents and paying the state fees. The paperwork and obligations required to form an LLC are considerably less than an S or C corporation. It eliminates the drawbacks of an S corporation while maintaining the benefits of an S corporation. There are different reasons that a busines
s owner may want to take this approach with his or her company.
One consideration is that if you anticipate losses for at least two years, you can pass this loss to yourself and any other owners. This will have a significant beneficial impact on your personal income tax. Also, an LLC can own real estate and can give you a great deal of flexibility in determining your management structure, accounting process, and reducing your organizational formalities. An LLC is not subject to holding to a set schedule of meetings for directors or keeping detailed records for all major business decisions. Corporations need to hold annual meetings, keep minutes, and carefully document pretty much everything. An LLC is a much looser structure to administer.
Professional Corporations (PC) & Professional Limited Liability Corporations (PLLC)
Licensed professionals have two other options for the structure of their business, called Professional Corporations (PC) or Professional Limited Liability Corporations (PLLC), and these have some specific advantages. In a Professional Corporation, only professionals licensed in whatever their specialty is can be the shareholders. For instance, you can have a group of doctors, a group of lawyers, etc. as shareholders. But remember — only members of the profession are the shareholders; there are no exceptions. For example: A doctor’s brother who is not a licensed physician cannot be a shareholder. The corporate organization of a PC allows its shareholders to have more direct control over managing its operations.
Professional Limited Liability Corporations are only allowed in certain states that established laws to form them. These are easier to set up than a regular corporation and have easier operational guidelines. However, not all states have these and if you are looking to operate in multiple states, you need to check if the PLLC is allowed where you want to establish offices or subsidies.
