Tax Differences for Businesses
Different business structures have different taxation rules, and the wrong structure for your business can lead to greater tax liability or unnecessary paperwork. First, incorporating your business (even if you are a sole proprietorship) creates a firewall between the assets and liabilities of the business and your personal monies. That said, there are various ways to incorporate: C corporation, S corporation, or limited liability corporation (LLC).
A C corp is its own legal entity, owned by its shareholders. Taxes are levied against the corporation on its net income or loss, and it is a taxpaying entity with requisite returns filed each year. Shareholders are paid via dividend distributions that are then also subject to taxation at the individual level as income.
An S corp is different in that it elects special tax status with no federal tax levied at the corporate level. Instead, the corporations’ profits (and losses) are “passed through” to the shareholders to be claimed on their individual returns. This eliminates the double taxation that occurs for a C corp. So with the elimination of double taxation, why would a business ever opt for C corp structure? The regulations for S corps are stricter: there can be no more than 100 shareholders, and those shareholders must be U.S. citizens and resident aliens. The accounting rules for S corps are also more complex.
An LLC provides an alternative. It offers the benefits of corporations in the protection of business owners’ personal funds and the ability to elect a taxation format. If an LLC is owned by a single member, then it is considered adisregarded entity by the IRS and will simply file taxes like a sole proprietorship. If an LLC has multiple members, then it will be taxed as a partnership unless the LLC elects to be taxed differently. An LLC can elect to be taxed as a C corporation or an S corporation thereby offering the required growth flexibility that most startup businesses desire.
While “pass-through” taxation seems like a great alternative (after all, why pay tax twice on the same earnings), if you derive your income from an S corp or LLC, you’ll likely have to pay self-employment tax. According to the IRS, “Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.”
It is important to keep in mind that self-employment tax is a tax in addition to regular income tax at the federal level.
For 2015, this tax rate was 15.3 percent on the first $118,500 of net income and 2.9 percent on net income exceeding $118,500. The breakdown is as follows:
- 6.2% as the employee’s portion of Social Security tax ($118,500 limit)
- 6.2% as the employer’s portion of Social Security tax ($118,500 limit)
- 1.45% as the employee’s portion of Medicare tax (no limit)
- 1.45% as the employer’s portion of Medicare tax (no limit)
Those required to pay self-employment tax may deduct the employer’s portion of the tax from income when figuring their adjusted gross income.
Limiting Self-Employment Tax
Self-employment tax applies only to earned income – salaries and wages. It does not apply to dividends you earn, and dividends are the distributions paid to you from corporations. This is where the S corp business structure (despite its regulations and restrictions) can pay off. If your business operates as an S corp, you can take 40 percent, for example, of your earnings as a dividend rather than a salary, so you’ll reduce the amount on which you pay self-employment tax by that much.
For example, if your earn $100,000 in your S corp and take $60,000 as a salary and $40,000 as dividends, your self-employment tax liability is $9,180 (rather than $15,300 levied on the entire amount), and you can deduct half of that ($4,590) from your federally taxable income. That means you pay income tax on $55,410 rather than $60,000 before other available deductions.
Even if you don’t operate as an S corp, there are ways to lower your self-employment tax liability. Start with deductions: Be sure you are taking every business deduction available including office space and supplies, advertising, commissions and fees, business travel, etc. If you’re self-employed, you can also deduct the cost of health insurance even if you don’t itemize to lower your adjusted gross income.
The tax laws and rates that apply to various business structures can be complicated, and improperly structuring your business can lead to greater unnecessary tax liability.Contact us and let us review your business structure to ensure you’re paying the correct amount of tax but not more!