If you are a business owner you are basically one of four types of entities: Sole Proprietorship, Partnership, S-Corporation, or C-Corporation.
These entities were set up to be recognized for tax purposes, unlike an LLC which is set up for protection purposes, not a tax entity.
A sole proprietorship is the most common entity businesses start out as because it’s easy to set up and is a good entity until you know how much money the business is going to make.
With a sole proprietorship, the income comes in and expenses are paid. Anything left is considered a profit and is taxable: federal and state (depending on the state the business is located).
Where owners can get into trouble is the social security or FICA tax. Business owners are aware of federal and state taxes but forget about FICA since it is normally just extracted from your paycheck automatically.
When they get the figure from their accountant after the tax return is prepared, it is usually the result of that FICA tax and there is no money in the bank to cover it. This is when the trouble begins! Not only will last year’s tax be due but ALSO 1st quarter’s estimated tax for the following year! BAM – double whammy!
A partnership works very similarly to a sole proprietorship. It’s easy to set up and is basically 2 or more sole proprietorships who have gotten together as business owners. As with a sole proprietorship, a partnership’s profit is subject to federal, state and FICA taxes. It has its own tax return but the profit/loss does come over onto the personal returns of the owners and thus that FICA tax sneaks up…AGAIN!
In an S-Corporation taxability is whereby the leftover profit itself is taxable to the individual shareholders’ tax return at their personal federal and/or state tax rate. There is no self employment tax in an S-Corp, which can be a huge savings.
It’s similar to a partnership in that the Schedule K-1 comes through for the profit/loss of the business. The difference is you do need to take payroll for whatever job function you are doing for the business. This will give the owner a normal W-2 and the FICA tax deduction will be taken.
The C-Corporation has its own nuances. With a C-Corp the owner(s) are on payroll and the profit is taxed at the corporate level which, based on the Affordable Care Act, is 21% across the board.
The profit DOES NOT come over to the business owner’s personal income tax but they are still taxed on the dividends they receive. So not only are taxes being paid on the corporate level, they are being paid on the dividends as well…DOUBLE TAXATION!
We recently worked with a new client and will show you an example of how each entity needs to be compared and contrasted by your CPA to save the most in tax dollars:
The business was a sole proprietorship. The profit for the year was $112,000. Under the sole proprietorship the federal tax and social security tax (we left out state tax since it varies too widely depending on the state lived in) came to about $35,000. This also included the Section 199A deduction of $16,000. Without having made any estimated tax payments, this is the figure the owner would have to write a check for.
Using the same numbers we worked up the tax estimate as an S-corporation. Since the owner needs to take a salary, we used $48,000 for that figure. Subtracting it from the $112,000 profit left $63,000. After the deduction for the Section 199A ($12,000) we were now at a taxable profit
Total tax came to $25,000 plus the $3,600 FICA tax from the owner’s salary—$29,000. Because an S-corp passes through to the owner’s individual tax return that same $112,000 profit the business earned reflects a $6,000 TAX SAVINGS as a S-Corp over a sole proprietorship. Just for being a different ENTITY!
Now with a C-Corp, taking the same $48,000 in salary, $63,000 in profit at the 21% corporate tax rate and factoring in the FICA tax paid on the salary, the situation is different.
If the owner were to take that $63,000 out in dividends, the money would be taxed FIRST at the corporate tax rate and AGAIN on the owner’s personal income tax, therefore costing a total of $45,000 in taxes!!! The C-Corp obviously was not the way to go in this example!
We know that every business situation is different. Just make sure you are meeting with your accountant regularly to determine the best entity for your business. Your CPA should CONTINUOUSLY be looking at your numbers before you reach those big profit numbers to minimize your tax liabilities with strategic tax planning.
Have these conversations with your accountant. If you don’t have an accountant or you feel yours is not looking out for your best interests, please give us a call or DM us. We are here to help! This is only ONE strategy out of the 64 we use to save our client’s money.
Don’t wait until December 31st to look at these numbers! Oh and hey, if there is a business owner you know who could benefit from this information, please share it!