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Choosing a Tax Entity that Minimizes Cost

Anthony C. Gruber, CPA


Business owners often choose a tax entity based on a perceived legal protection. But it’s also very important to understand the tax ramifications of choosing one legal entity over another. The wrong entity choice can cost the shareholder(s) thousands in tax dollars each year; even hundreds of thousands depending on the company’s income! In addition, as your company changes, the optimum entity choice will also change.

There are 5 basic entity choices for a typical business: Sole Proprietorship, Partnership, Limited Liability Company (or Limited Liability Partnership), Corporation, and Sub-chapter S Corporation (aka S-Corp). Each choice can be treated very differently for tax reasons. Each entity also has different rules regarding what is deductible for tax reasons and what isn’t. There are also different rules regarding how shareholders can take money out of the company.

This course discusses the critical characteristics of each entity in order to draw and meaningful and understandable distinction between each entity choice: There is a table at the end of this course that provides a comparison of each entity. You should find this table very useful after you have read the article.


Sole Proprietorship – A default entity:
Let’s say you start doing business and earning money. If you don’t actively choose an entity (by filing the proper paperwork), you are a Sole Proprietorship. A Sole Proprietorship is taxed the same way as a Partnership and an LLC (in most cases).

The biggest advantages of the Sole Proprietorship are there are no set-up costs, and the record-keeping requirements are easier than other entities.


Partnership – Another default entity:
If you and some friends pool your resources and start doing business together, you are part of a Partnership (assuming you didn’t actively choose an entity). This illustration shows how easy it is to create a partnership: It's not a suggestion! We strongly recommend that you do not enter a Partnership before obtaining a written understanding of ownership percentages, duties, initial investments, etc., etc..

Partnerships are taxed the same way as Sole Proprietorships and LLCs: An LLC can elect to be taxed as a Corporation or an S-Corp, but that discussion is beyond the focus of this course.


Limited Liability Companies (LLCs):
LLCs, LLPs, Sole Proprietorships, and Partnership are basically taxed in the same way for federal purposes. Company taxes are paid by the owners, rather than the entity.

LLCs and Partnerships with more than one shareholder must file a federal form 1065, and give each shareholder a statement (form K-1) showing his/her share of taxable income generated by the company. If there is only one owner, the owner files a Schedule C form on his personal tax return.

Income from these entities is subject to federal income tax as well as self-employment taxes (FICA and Medicare). However; if you are a passive investor (IE: You own part of the company, but you don’t have any management responsibilities – aka active participation), then your portion of income is not subject to self-employment tax.

It is not necessary to run a payroll for an LLC unless you have employees. Owners can take money out of the company at any time, though it should be done in accordance with a partner agreement.
If an owner takes money out of these entities, it’s usually considered a reduction of his / her investment and not a taxable distribution.

Partnerships can elect to provide payments to certain partners for services rendered to the company. Their compensation doesn't have to be paid thru Payroll. This type of distribution is called a Guaranteed Payment.
A Guaranteed Payment is reflected on the shareholder’s K-1, and is subject to Income Tax as well as Self-employment taxes. Guaranteed payments are deducted from all Partner earnings for tax purposes, just like any other deductible company expense.

This illustration should help put these concepts into perspective:
Assume two equal partners: Each contributes $200,000.
Company sales were $150,000 in the first year.
Partner 1 gets a guaranteed payment of $50,000 per year.
Each partner takes a draw of $100,000 in the first year.
The partnership’s taxable income is $100,000
(150,000 less the 50,000 guaranteed payment.)

Partner 1's capital account is $150,000 at the end of the year:
Initial Deposit $ 200,000
Income - 100,000/2 50,000
Partner Draw (100,000)
------------
Partner 1's Balance $ 150,000
Partner 2's capital account is also $150,000 at the end of the year:
Initial Deposit $ 200,000
Income - 100,000/2 50,000
Partner Draw (100,000)
------------
Partner 2's Balance $ 150,000

Partner 1's taxable income (from the Partnership) is $100,000:
Partner 1's Share of Income
100,000 / 2
$ 50,000
Partner 1's Guaranteed Payment 50,000
------------
Partner 1's Income $ 100,000
Partner 2's taxable income (from the Partnership) is $50,000:
Partner 2's Share of Income
100,000 / 2
$ 50,000
Partner 2's Guaranteed Payment N/A
------------
Partner 2's Income $ 50,000

Observations:
  • Partner 1’s taxable income is $50,000 higher because of the Guaranteed Payment, which was deducted from income to arrive at the partnership’s taxable net income. IE: Income (after guaranteed payments) is recognized ratably by the partners.
  • Guaranteed payments are taxable income to the recipient.
  • Partner draws are NOT taxable income. Each Partner’s draw is treated as a direct reduction to the specific Partner’s Capital account.
  • Income (after guaranteed payments) is treated as a direct ratable increase in each partner’s capital account.


Corporations:
Corporations must file a form 1120 each year. Income taxes are paid by the Company. In 2008, Corporate tax rates started at 15%; and the highest rate was 35%. Small companies that provide certain professional services can be designated as a Professional Corporation (PC). PCs paid a flat rate of 35% in 2008, no matter what the income level.

Corporations can provide a tax advantage because they provide the shareholder(s) with two separate tax tables, the personal table and the company table. The Corporate tax rate starts at 15%, and the tax rate at the personal level starts at 0%; so you can see there is an advantage to be gained by exploiting these lower brackets. This advantage starts to disappear as the business matures and income rises.

Most states have strict requirements on the way Corporations are operated. For instance, the company must appoint officers and a board of directors. Major decisions must be approved by the board, and the board is required to meet at least once a year. Philosophically; Corporations were designed to be owned by passive investors, so officers and board members exist to protect the interest of the shareholders.
In practical application; many Corporations are owned by one or two owners who actively participate in the company. Even if there’s only one owner, he/she must still appoint Officers and a Board of Directors. Some owners appoint themselves (or family members) in all key positions, which is a legal way to wink at the statutory rules. We won’t comment on the deductibility of a Florida vacation as a board meeting!

Please Note: Objective over-site is a great idea, whether you are a SP, LLC or a Corporation. All Companies should consider appointing experienced and qualified board members: Any company would greatly benefit from a good board!

Owners have limited options regarding how to take money out of a Corporation:
  • Payroll: Actively involved shareholders can take a “reasonable” payroll.
  • Dividend: Dividends must be paid ratably to the shareholders, and they must be approved by the board. The tax rate on dividends is currently 15% at the personal level, so this is not an expensive option. Dividends are not a deductible expense to the Company, so they are often referred to as a “double-taxed” item – The income is taxed once by the Corporation, and then it’s taxed again at the personal level as a dividend. Companies often keep this in mind when contemplating a dividend.
  • Consulting Fee: A shareholder could provide a service to the company and take a fee. The fee must be reasonable, and the relationship should be approved by the board. The common term used to describe the relationship requirement is “arms-length transaction”. This means the fee must be competitive, and in the best interest of the shareholders. The fee (whether it’s a management fee, loan interest, product sale, etc.) must be similar to what the company could get from an unrelated third party.
    Owners cannot take tax-free distributions out of a Corporation. Distributions from a Corporation will always trigger a taxable event, unless it’s a deductible expense reimbursement or a loan. Keep in mind that a loan must also be treated as an arms-length business transaction.


    Sub-Chapter S Corporations (S-Corps): The Hybrid. S-Corps must file a form 1120-S each year, but Federal income taxes are paid by the shareholders. Each Shareholder is given a K-1 which reflects his/her portion of the taxable income generated by the company.

    Income generated by an S-Corp is NOT SUBJECT TO SELF-EMPLOYMENT TAXES. For this reason, the S-Corp is the preferred entity of some accountants no matter what the income level of the company. This advantage only becomes predominant under certain circumstances, so accountants who put all their clients in an S-Corp are not always serving the client’s best interest.

    Most states have strict requirements on the way Corporations and S-Corporations are operated. For instance, the company must appoint officers and a board of directors. Major decisions must be approved by the board, and the board is required to meet at least once a year.

    Shareholders of an S-Corps must follow strict rules regarding how money is taken out of the company:
  • Payroll: Actively involved shareholders must take a “reasonable” wage via payroll. There is a temptation to minimize shareholder wages in order to avoid FICA and Medicare taxes. Keep this in mind though. If officer salaries appear too low on the 1120-S, it could trigger an IRS audit. If it is determined that wages were set for the express purpose of minimizing taxes, they could be adjusted in the audit, creating additional taxes, penalties and interest.
  • Shareholders CAN take money out of an S-Corp. Like an LLC, Shareholder distributions are considered a reduction of a shareholder’s investment and not a taxable distribution. Distributions should be paid ratably to the shareholders, and they should be approved by the board.
  • Consulting Fee: Keep in mind that the fee must be an “arms-length transaction”. This means the fee must be competitive; a good deal for the company. The charge (whether it’s a management fee, loan interest, product sale) must be similar to what the company could get from an unrelated third party.

    The S-Corporation is the most time-consuming entity to manage because it encompasses all the statutory rules of the Corporation, plus:
  • there is an obligation to monitor payroll more closely,
  • each shareholder’s portion of taxable income must be calculated and provided in a timely fashion, and
  • the company must often coordinate with shareholders and their tax preparers in order to ensure the proper filing of the shareholders’ tax returns as they relate to income created by the company.
    The additional administrative cost associated with S-Corporations depends on the number of shareholders involved and the number of States the company is located in.

    The table below illustrates the major differences between LLCs, Corporations, and
    Sub-chapter S Corporations:

    Entity Comparison Table:

    Limited
    Liab.
    Comp.
    S-Corp Corporation What's the Difference?
    Why is this issue
    important?
    Separate return required
    for Single Owner Entity?
    No Yes Yes This creates additional
    administrative expense
    for the company.
    Income Taxes Paid by the
    Company or Shareholders?
    S/H S/H Company A Separately Taxed Entity
    Creates Unique Tax
    Planning Opportunities.
    Company Profits Subject to
    Self Employment Taxes?
    Yes No No In 2008, Self-Employment
    taxes were 15.3% for the
    first $102,000 earned.
    2.9% after that.
    Distributions to Shareholders
    Taxed as a Dividend?
    No No Yes Double-taxation could be an
    issue. Dividends are
    taxed at the company level,
    and the personal level.
    Active Shareholders
    required to take a
    Reasonable Salary?
    No Yes Yes The IRS could second-guess
    what you're doing.
    If wages are found to be
    set for tax planning
    purposes, they could be
    adjusted in an audit.

    As you can see, different entities are treated very differently. Each entity has certain advantages and disadvantages when compared to other entity choices. In fact, companies will obtain the greatest benefit from different entity choices at different stages of the business!

    There are many variables to consider when deciding which entity will help minimize costs the most:
    • Projected annual income for the next few years.
    • The company’s line of business (IE: Could the company be considered a Personal Service Company?).
    • Tax status of the business owner(s). Is this their only source of income? What is the owner’s marginal tax bracket?
    • What do the owners plan to do with company profits? Use them for future growth, or take them out of the company?
    There are other considerations, but these are the primary issues that should be agreed upon in order to make a strategic decision.

    Conclusion:
    You should now have an understanding of the primary complexities involved with choosing the right entity for your company from a cost perspective. This is a very important consideration since there are several entities that adequately provide the legal protection sought after by many small business owners.

    The right entity choice can be systematic (and objective) as long as all critical variables are taken into consideration. We recommend every business make a deliberate choice regarding which entity they use. We also recommend consulting a CPA when making this important decision. Companies should review their options every 2 to 3 years.


    About the author:
    Mr. Gruber has been a CPA for over 20 years. He founded Gruber and Company in 1990. He also has 15 years experience as a full-time CFO and change agent. His firm created an entity comparison tool in order to help the small business community make a more informed choice regarding which entity works best for their situation. This tool is not designed to replace a professional consultant, but it should help reduce the cost of an entity planning engagement. You can find this tool at
    www.projectedfinancialstatements.com/pages/freetools.asp
    This is one of many tools that Gruber and Company developed for in-house use, and then made available on their web-site for a price that all small businesses can afford.


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