Legal Entity Optimization
Picking the right business structure can come down to quite a few factors. If taxes are a primary concern, we can give a tax analysis so you can achieve legal entity optimization.
Sole Proprietor
Use Schedule C to report income or loss from a business you operated or a profession you practiced as a sole proprietor. A Schedule C is also used to report the income and expenses you would have as an independent contractor or when you have a side gig if you do not choose another entity structure.
This type of business is very easy to set up as it does not require you to form another legal structure. It also does not require that an additional tax return be filed, as the Schedule C is filed as part of the Individual (1040) return.
A Schedule C does not provide any legal protection. You can be held personally liable for the debts and obligations of the business. This risk can be mitigated by forming a Limited Liability Company (LLC) for the business.
A major drawback of having a business taxed as a Schedule C is that all of the net profit is taxed for both income tax and for self-employment tax.
Many low-risk businesses start as a Schedule C, but then convert to another entity as they become more successful and can benefit from the additional liability protecting and tax savings found in other legal entities.
S Corporation
S Corporations are not taxed at the corporation level. Instead, they pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S Corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S Corporations to avoid double taxation on the corporate income.
One major benefit of an S Corporation is that not all earnings may be subject to self-employment tax. An S Corporation shareholder is an owner-employee of the business. This means that the net profit from the business is a blend of self-employment income and a return of capital from the shareholder’s investment in the business.
The self-employment component is paid out as wages and is subject to self-employment tax. The return on the investment is paid out as a distribution and is not subject to self-employment tax.
To prevent 100% of the earnings from being treated as distributions (and not paying self-employment tax), S Corporation shareholders are required to take “reasonable compensation.” Amounts taken as reasonable compensation are treated as wages, and the shareholder and corporation will pay FICA and Medicare taxes on those wages. Since only a portion of net profit is subject to self-employment taxes, business owners can see significant savings on self-employment taxes. These are not one-time savings but are available if the S Corporation is in business.
All net profit, whether distribution or wages (reasonable compensation) is still subject to income tax.
C Corporation
In a C Corporation, the company’s earnings are taxed at the C Corporation rate, rather than at the individual’s tax rate. The owner is not required to take profits out of the C Corporation, and they can be retained within the corporation. This allows the total tax to stay at the lower C Corporation rate. However, if the individual decides to take out profits from the company, the individual will also be taxed on those dividends in addition to the income taxes on the earnings at the C Corporation level (double taxation).
In a business where substantial profits are being reinvested into the business rather than being distributed to owners, a C Corporation structure may be more beneficial. Under TCJA, corporate income tax rates are a flat 21% where individual tax rates on pass-through income are likely much higher. The tax savings calculation will be the difference between the individual owner tax rates and the corporate tax rate.
C Corporations can be a good way to provide valuable fringe benefits to the employees of the corporation, including the shareholders.
A C Corporation is a separate legal entity and does provide personal liability protection to the shareholder for the debts of the business. However, as a separate entity, an additional income tax return must be filed. There are also additional paperwork requirements for the C Corporation, such preparing the Articles of Incorporation and recording meeting minutes.
Partnership
A partnership is an entity owned by two or more people for a trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.
A partnership does not pay tax at the partnership level, but instead passes through the income, deductions, gains, losses, etc., from its operations to its partners. Each partner reports their share of the partnership’s income or loss on their personal tax return.
Partners are not employees, and do not receive a W-2 from the partnership.
Partnerships are extremely flexible, with the terms of the partnership set forth in the partnership agreement. Included in the partnership agreement will be the per partner allocation of income and losses.
A partner can be either a general partner or a limited partner. The general partner is involved in the day-to-day operations of the business. Each partnership must have at least one general partner.
General partners are subject to both income tax and self-employment tax based on their percentage of income from the partnership. General partners may also be personally liable for the debt of the partnership and their other partners.
Limited partners are investors in the partnership and are not subject to self-employment tax but are subject to income tax on the net profit of the business. Limited partners typically are not liable for the debts of the business.
Some partnership agreements may include guaranteed payments to certain partners based on services provided or capital invested. Guaranteed payments are subject to self-employment tax to the partner that receives them, even for limited partners.
Legal Entity Optimization
Contact LNK Tax Group at 661-491-7222 or 213-588-1120 or you can book a free consultation online to learn more about maximizing tax deductions. We provide tax consulting and tax planning on maximizing tax deductions to businesses in Downtown Los Angeles and Santa Clarita including, Valencia, Stevenson Ranch, Newhall, Castaic, Canyon Country, Agua Dulce, Saugus, Rancho Santa Clarita, Sylmar, Mint Canyon, Val Verde, Mission Hills, Castaic Junction, Granada Hills, Porter Ranch, San Fernando Valley, and Los Angeles County.