Taxing Choice-of-Entity Decisions
“If you get up early, work late, and pay your taxes, you will get ahead–if you strike oil.”
–J. Paul Getty
Deciphering which entity type provides better tax shelter for a particular business depends on the business’ specific goals and policies. There is no universal prescription in this department. But different tax characteristics inherent to each entity serve to inform strategy on entity selection and fiscal protection while the business grows.
Double Taxation (C-Corporations)
Problem: Common knowledge holds that C-Corporation shareholders get taxed twice: once at a corporate-income level for profits earned by the corporation, and once again at a personal-income level when the profits are distributed as dividends to shareholders. S-Corporations and LLCs, on the other hand, are flow through entities – getting taxed only on the distributions to shareholders/members. Double taxation cannot be avoided entirely, which is a major disadvantage for C-Corporations. But there are strategies to mitigate its effect on the bottom line.
Strategy: Shareholders will often opt to pay themselves as salaried employees, with bonuses, instead of distributing the cash as a dividend. Since salaries and bonuses are deducted as an expense from corporate-level revenue, the corporation does not pay corporate-level tax on that income. In effect, this zeros out the taxable profit, while still distributing the cash its shareholders, who will only pay tax once on personal income. This is a good approach to avoid double taxation. But it is limited.
Limitation: C-corporations may only deduct “reasonable” compensation paid to its employees. If the IRS determines that a business disguised its profits (which should be distributed as dividends) as bonuses it will recategorize the bonus as a dividend, and then charge interest and penalties on the resulting increase in income. The result of which will end with less profits than if the corporation had simply paid the double tax in the first place.
Counter Strategy: To avoid recategorization by the IRS, the C-Corporation may split the profits between bonuses and dividends and/or pre-designate a portion of the company’s profits for dividends at the beginning of the fiscal year. Furthermore, the business might make bonuses contingent on specified financial goals rather than on the shareholder’s percent ownership in the company, the latter of which appears more akin to a dividend. The argument for basing bonuses on financial goals is that it is not entirely different from paying sales people commission on sales targets, which are rarely, if ever, reclassified as dividend payments.
Bottom Line: Double taxation is an enduring disadvantage for C-Corporations when compared to the flow through tax status enjoyed by S-Corporations and LLCs. But this factor alone is not completely instructive: unlike S-Corporations and LLCs, C-Corporations do not pay self-employment tax.
Self-Employment Tax (S-Corporations and LLCs)
Problem: Although not subject to double taxation, S-Corporation and LLC owners must pay 15.3% self-employment tax on income earned through the business. But there is a significant difference between LLCs and S-Corporations. All distributions to LLC members – whether by salary, bonus, or owner draw – is subject to personal income plus self-employment tax. S-Corporations, on the other hand, only pay self-employment tax on profits distributed as salary or bonus, but not on distributions made as dividends; those are self-employment tax-free. Further comparing to two, LLC members can deduct up to half of the self-employment taxes from adjusted gross income; ultimately reducing the amount of income tax due. The specifics of any given business will dictate the ultimate result in this debate. Generally speaking, however, S-Corporation shareholders will pay less in Medicare and Social Security taxes than LLC members. Assuming the S-Corporation is elected, there are strategies for minimizing self-employment tax.
Strategy: S-Corporations may set low salaries and avoid distributing bonuses to shareholders. Instead, distributing profits through dividends. S-Corporations will enjoy the best of both worlds since there is no corporate-level tax and there is no self-employment tax on dividend distributions.
Limitations: Like C-Corporations, S corporations are required to pay shareholder-employees a reasonable compensation. If the IRS determines that these shareholders have set pay levels unreasonably low, it will reclassify the dividends as salary and sanction the S-Corporation with additional fees and fines.
Counter Strategy: One approach to take advantage of flow through taxation while avoiding self-employment tax is to set up both an S-Corporation and C-Corporation to manage and execute different aspects of the business. This multi-entity approach is more complex, and, as a result can be more limiting operationally. But if the formalities are observed, this approach may prove financially worthwhile as a result.
Bottom Line: Self-employment tax cannot be avoided completely, but there are strategies available to S-Corporation owners that will minimize the taxing impact.
Comparing Some Numbers
C-Corporations incur federal corporate-level tax on taxable income at graduated rates. The first $50,000 is taxed at a 15% or $7,500 for the full $50,000. Assuming then that the corporation paid a dividend for the remaining $42,500, it would be taxed again, at 15% for the $42,500, or $6,375. Therefore, $50,000 – $7,500 – 6,375 = $36,125 remaining for the shareholder.
LLCs and S-Corporations are pass through, which means the profits or dividends, respectively, are taxed at the personal income rates. So if $50,000 was generated by an LLC or S-Corporation and the owner had annual income of $186,350, for example, the federal tax rate would have been 33%, or $16,500. Thus, $50,000 – $16,500 = $33,500 to the owner. Here, the C-Corporation saves the owner $2,625 over the LLC and/or S-Corporation.
If, on the other hand, the LLC or S-Corporation owner had an annual income of $36,900, for example, the $50,000 would be taxed at 25%, or 12,500. Thus, $50,000 - $12,500 = $37,500 for the shareholder. Here, the S-Corporation or LLC saves the owner $1,375 over the C-Corporation.
As a final example, let’s assume the dividend or bonus is $1,000,000 with a salary of $100,000. Under an S-Corporation or LLC the approximate total tax for the owner is $390,191 (potentially subject to an additional Medicare tax of: $8,100), leaving $601,709 for the owner.
With a C-Corporation, the graduated tax schedule requires tax of $113,900 + 34% of the amount over 335,000 (computed as, [0.34 * ($1,000,000 - $335,000)] = $226,100). Thus, $1,000,000 – $113,900 – $226,100 = $660,000. This is taxed again at $113,900 + 34% of the amount over 335,000 (computed as, [0.34 * ($660,000 - $335,000)] = $110,500. Thus, $660,000 - $113,900 - $110,500 = $435,600 remaining for the shareholder. Therefore, the LLC or S-Corporation structure saves the owner approximately $166,109 over the C-Corporation in the final example.