The type of business entity you choose directly impacts your Federal tax obligation. Choosing the right entity can reduce your overall tax, when your tax is paid, along with how it is paid.
When structuring your business you will encounter multiple forms for conducting business. Depending on your situation you may choose to be taxed as a C Corporation, Subchapter S Corporation, Limited Liability Company, Partnership, or Sole-Proprietorship. From a “pure” tax perspective a C Corporation is subject to “double taxation.” This double tax occurs as the corporation is responsible for paying its own tax at the Federal level while its owners are forced to pay tax on the salary they receive along with any dividends paid to them. Additionally, upon sale of the company the owners will be taxed twice on the sale, once at the corporate level, and then again as investors. Other pass-through entities, such as, Subchapter S Corporations, Limited Liability Companies, and partnerships are taxed only at the owner level. These entities generally pay no taxes at the Federal level and instead pass their income through to their owners. Sole-Proprietorships have no separate Federal filings and all income is included on the owner’s Federal 1040.
At first glance, pass-through entities might seem like a better choice as they are typically taxed once on their income. However, pass-through entities have two key problems; (1) the income is subject to tax whether or not it is actually paid out to the owner; and (2) in some instances, the profits from pass-through entities may be subject to self-employment taxes depending on the owners level of involvement.
Impact of Self-Employment Taxes
When business owners receive a share of income from a pass-through entity, the income may not only be subject to Federal income taxes, but also self-employment taxes. Self-employment income is subject to a Social Security (OASDI) rate of 12.4% on the first $113,700 of income and a Medicare rate of 2.9% without regards to an income cap. Additionally, beginning with the 2013 tax year these same earnings may be subject to an additional .9% Medicare tax as part of the Patient Protection and Affordable Care Act (PPACA). As a result of the self-employment tax impact one may feel that the cost-benefit analysis is shifted in favor of the C Corporation. This can be true if a C Corporation is subject to a low enough corporate tax rate and its earnings are more favorably balanced with its owners between dividends and salaries.
Another way to further reduce C Corporation taxes is by offering certain benefit plan alternatives to the owners. Benefits offered to owners by a C Corporation are frequently not subject to income or self-employment taxes (OASDI and Medicare), and the savings generated for benefits like 401(k) contributions and health insurance generally outweigh the costs to provide them.
The S Corporation - "A Just Right" Solution
If the cost of self-employment taxes or a C Corporation structure does not sit well with you then the S Corporation might be the “just right” alternative. With an S corporation you are required to pay yourself a reasonable salary based on your position and the level of service that you provide. On that salary, you'll be subject to standard FICA and Medicare withholding taxes. The remaining S Corporation earnings will be taxed at ordinary income tax rates. The balance of your after-tax earnings can then be taken out in the form of distributions which are not subject to self-employment tax. However unlike C Corporations, benefits offered to S corporation officers are frequently subject to FICA and Medicare taxes as well as income tax.
Choosing Your Entity
Choosing the form of your business isn't as simple as you might think at first glance. The old rules of thumb don't always apply in a given situation. The best way to figure out which form your entity should take is to sit down with a tax expert to see how you can best minimize your tax liability while also providing you with the flexibility to manage your business. Contact us if you'd like to get started on this process.