The first tax deadline for S-Corporations and Partnerships is next week, and I’m fielding a lot of questions around the S-Corporation election. Many small business owners think or have been told that the S-Corp election is the way to reduce taxes for your business, because it gives you the ability to save on self-employment tax. Unfortunately, blanket advice like that doesn’t always make sense. Whether to elect this status for your business as an S-Corp. or not, is a technical question with broad implications. Today, I want to talk a little about different small business structures, how they affect your taxes and what you should consider in choosing the structure that’s right for you.
Small business organizational structures
The simplest form of business organization for very small companies is sole proprietorship, where you and your company are essentially the same entity. That works up to a point. But what if your business gets sued? You could lose your house, your personal savings, college accounts for your kids, even your car. If you want to shelter personal assets from legal liabilities, you have a choice between few other business structures.
Single Member LLC
To avoid the unlimited liability of a sole proprietorship, you can turn to a single member LLC (Limited Liability Company). LLCs are straightforward to administer, and in most cases, you’ll still report income on a Schedule C. But you gain some protection because your business is considered a separate entity.
In an LLC, you are only liable for damages up to the amount that you have invested in the business. However, you should make sure to keep your personal and business assets separate to prevent someone from “piercing the corporate veil.” Simply put, that means a creditor can sue for your personal assets because your business and personal assets are commingled and your LLC only serves as a shell for a separation that doesn’t actually exist.
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You also have to take a few more steps to set up a LLC than you do for a sole proprietorship. You have to file articles or organization with your state, and you should have some sort of operation agreement that explains how the business will carry out its mission.
One last potential pitfall of the LLC is that you have to pay self-employment tax on all business profits because, for tax purpose, you and the business are one in the same. The self-employment tax rate is 15.3%, which consists of 12.4% in for social security and 2.9% for Medicare. You may remember these amounts that were withheld from your pay stubs when you were an employee.
A partnership is a business shared by multiple owners. A partnership is similar to a sole proprietor in that the business isn’t separate from the owner for liability purposes.
Depending on the type of partnership, you may or may not have to register with the state. Partnerships fall into four categories:
- General Partnership: Ownership, profits and liabilities are generally split evenly among partners and partners have equal ability to bind the business to contracts and loans. All partners participate in the day-to-day operations of the business.
- Limited Partnership: Here, there is at least one general partner who is responsible for the business and its operation and one or more limited partners who invest financially but do not actively manage the business and don’t have liability for any more than they’ve invested in the business.
- Limited Liability Partnership (LLP): All partners actively manage the business, but have limited liability for one another’s actions. LLPs are not permitted in all states and usually only pertain to certain professions such as doctors, lawyers, and accountants.
- Limited liability limited partnership (LLLP): Like an LLP, this type of partnership is only available in some states. It operates like an LP, with at least one general partner who manages the business, but the LLLP limits the general partner’s liability so all partners have liability protection
For tax purposes, the business files Form 1065 and each partner receives his/her/their share of the business profits and losses on a K-1. The payments are then taxed to the individual on their income tax return and subject to self-employment tax as with a sole proprietor and LLC. A partner may also receive guaranteed payments, not tied to their partnership share, for services in the business.
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits to their shareholder for federal tax purposes. Thus, the corporation is not subject to tax itself. Instead, shareholders of S Corporations report the flow-through of income and losses on their personal tax returns and are assessed taxes at their individual income tax rates. An S-Corp isn’t a type of business structure as much as it’s an elected tax status. That status, however, comes with operational costs.
To create an S corporation, you have to file articles of incorporation with the state, appoint officers and create bylaws for the business. In addition, you have to adhere to corporate formalities including meetings of the board of directors and taking meeting minutes (even if you’re the only one in the meeting!). You will have to file a Form 1120-S for the business, and the business profit or loss will flow through to you personally on a Form K-1. Lastly, you can make the election to be taxed as an S-Corp if you’re an LLC or Partnership. More on that below.
Many one- or two-person businesses find these requirements too time-consuming and expensive. Additionally, some states, like Illinois and New York, levy additional taxes on and costs for S-Corps. But you can obtain significant tax savings if your business ends up making a substantial profit.
Determining the perfect salary
Before the Tax Cuts and Jobs Act (TCJA), most of the talk around choosing an S-Corp vs. LLC or partnership revolved around the self-employment tax savings which I mentioned above. For example, if you were an accountant who made $200,000 in net business income and gave yourself a “reasonable salary” of $100,000, you’d save $15,300 in tax by having an S-Corp vs. an LLC or partnership. That’s a nice chunk of change.
The key issue here is what constitutes a reasonable salary. This issue has long been contested, as people tend to push reasonable limits in order to save in self-employment tax. Business owners have even more incentive now that the Qualified Business Income (QBI) deduction only allows a 20% deduction for profits from the business, not salary. (You can read my business owner cheat sheet on QBI here.)
The IRS determines reasonableness on a case-by-case basis but offers a multiple factors as guidelines. These include your role and duties in the company, your background and experience and amounts paid to others in similar-situated businesses. It’s a grey area, but experts have developed some rules of thumb — for example, the ideal salary is somewhere between 30-45% of net business income, or, the “perfect salary” is 28.57% of your income.
While I love a good rule of thumb, small business owners who are making the decision between these entities need to take extra precautions. If your business revenue comes mostly comes from your services, the IRS will likely see all of your business income as your salary. In other words, all of you solo accountants, advisors, etc. need to consider the fact that it may not be reasonable for you to have any dividend income at all. That fact defeats the purpose of having a more costly and burdensome S-Corp. This situation is less likely the case if you are a part of a partnership where many people contribute to the business income.
Here are a few court cases that can she a bit more light on the subject:
- Spicer Accounting, Inc., Plaintiff-appellant, v. United v. United State of America, Defendant-appellee, 918 F.2d 90 (9th Cir. 1990) Spicer was the president, treasurer and director of his corporation Spicer Accounting Inc., He was the lone accountant in his firm. He received no compensation for his services but did take distributions (and thus paid $0 in payroll taxes). The district court held that Spicer was an employee and that payment to him were wages. The 9th circuit affirmed the district court’s ruling finding that as the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits, and preparing opinion letters. Thus, his services were “integral to the operation of the firm” and all payments to him should be considered wages subject to FICA and FUTA tax.
- Sean McAlary LTD, Inc. v. Commissioner of Internal Revenue, T.C. Summary Opinion 2013-62. McAlary was a real-estate agent. He was the president, secretary, treasurer and sole director and the sole shareholder of his S-Corporation. He managed all aspect of his corporation’s operations and was the only one in the firm that held a broker’s license. However, he did supervise eight independent contractor sales agents, four of whom generated sales for him. McAlary paid himself $24,000 per year and took a $240,000 distribution. The IRS determined that $100,000 of the $240,000 as reasonable compensation basing it on the median hourly wage for real estate brokers in California. The Tax Court took an even smaller figure of $83,200 basing it on $40/hour. The key factor here seems to be that while the only shareholder in the S-Corp, McAlary wasn’t the only one producing income. Thus, not all of the distributions were wages.
- Glass Blocks Unlimited v. Commissioner of Internal Revenue, T.C., Summary Opinion 2013-180. Frederick Blodgett was the president and sole shareholder of his S-Corp that sold and distributed glass blocks. The firm had no other full-time employees, and Blodgett was responsible for all operation and financial decisions for the company. Although he did not receive a salary, Blodgett received $30,844 and $31,644 in distributions from the company in 2007 and 2008. The IRS argued those entire amounts should be considered wages. The Tax Court agreed finding that “any officer who performs more than minor services is considered an employee, and his or her wages are subject to the employer’s payment of Federal employment axes. Blodgett tried to claim that a reasonable salary would have been $15.25/hr for 20 hours a week based on wages for a shipping clerk, an accounts receivable clerk, or an accounts payable clerk. But the court did not find his argument persuasive, as he performed all of those roles within the company and generated all the business’ sales and income from those periods.
How to choose
These regulations are somewhat murky, and by now, you may be wondering if there’s any way to arrive at the right decision about business structure. My hope is to equip you with enough knowledge and tools to have an effective conversation with your tax or financial advisor. In that discussion take into consideration the following questions:
- What type of business do you have? Service businesses effect both the reasonable salary requirement and the ability to take the QBI deduction.
- What are your business goals? Do you want simplicity and like less structure? Maybe an LLC or partnership is for you. Would you rather pay everyone involved a steady salary and take distributions? Think about having an S-Corp.
- How much of the income is derived from your work? Check out the IRS multi-factor reasonable salary test.
- Are you able to follow corporate formalities? You can hire someone to help with this.
- How much of your net business income is above or below the social security wage base ($142,800 for 2021)? The more above the wage base, the more appealing the 20% QBI deduction.
- Which retirement vehicles are you using? A single-member LLC allows you to save faster with a Solo 401k. If you have multiple people and/or employees, you will have to consider other retirement vehicles like a 401k or SIMPLE IRA.
Also, keep in mind that you don’t have to choose right away. As a single member LLC or a partnership, you can elect to be taxed as an S-Corp, as long as the election is made no more than two months and 15 days (3/15) after the beginning of the tax year you want the election to go into effect. You make the election on Form 2553. You can also withdrawal that election by writing a letter to the IRS regarding your intentions.
One final word of caution: do not make these decisions in a vacuum. The savings in self-employment tax and QBI deduction will have to be balanced against one another. And, as always, you should keep your purpose, vision and values of your business at the forefront of your decisions. Additionally, a change in entity type can have long-lasting implications. We don’t know if the QBI deduction will be around after 2025. So, talk to your tax and financial advisor to see how these provisions will affect you.