Updated: Apr 23, 2019
There are 2 reasons to start a business: (1) saving money on taxes from income producing activity, and (2) protecting your personal assets from creditor liability. This post concerns saving money on taxes.
Saving money on taxes
All money earned is subject to a Social Security tax and a Medicare tax. The Social Security tax is 12.4% and the Medicare tax is 2.9%. When you are doing business on your own, you pay this entire tax on your own. This is known self-employment tax. However, when you do business under certain types of business structures, the taxes are split equally between an employer and employee. This is known as payroll tax.
The owners of sole proprietorships are considered self-employed and will be liable for the full 15.3% self employment tax. Owners of corporations and partnerships are not considered self employed, except for general partners of partnerships. A general partner is a partner that is personally liable for partnership debts and is not commonly found anymore, especially since the introduction of LLCs. Corporations and partnerships pay payroll taxes on the wages of employees. Thus, owners of these entities can pay Social Security and Medicare taxes at half the rate of a sole proprietor. This, however, does not consider the corporate tax structure. A corporation is taxed twice; once as money is earned by the corporation, and again as the money is distributed to individuals whom file income tax returns. This means that, while a corporation may save money on Social Security and Medicare taxes, the total tax bill may be higher.
This analysis poses a problem for sole proprietors. Is a sole proprietor doomed to pay 7.65% more in taxes than a partnership? Not necessarily, under the business structure of an LLC.
An LLC is special in that it can choose how it wants to be taxed. In theory, a single member LLC could elect to be taxed as a partnership and lower its tax bill by 7.65% immediately. However, there is a rule that a single member LLC can only elect corporate tax status, or else the tax status of the LLC will be disregarded and the IRS will consider it a sole proprietorship. Fortunately, there are two types of corporations: the C corporation and the S corporation. The C corporation is the double-taxed entity discussed previously that pays taxes at the corporate level and the shareholder level. An S corporation is a special type of corporation that is also a pass through entity. S corporations have special formation rules, but can be owned by a single member. Remember, however, that the business of the single member is still an LLC whom is simply electing to be taxed as an S corporation, so they will not have to comply with some of the formation rules and complexities. They simply have to file an S corporation tax return in addition to their individual tax return.
There is 1 catch: the member of the S corporation must pay himself a "reasonable salary". Remember that payroll taxes are the same as self-employment taxes, just split between the employer and employee. Income treated as a shareholder distribution avoids this, but wages trigger the payroll tax. Since you will be both the employer and the employee in this situation, you will be paying the self employment tax on whatever amount a "reasonable salary" is. Some people find it difficult to come up with a figure for what a reasonable salary is. I would simply search employment sites such as Glassdoor and Indeed to see what other people in that industry, job title, and experience are being paid. The lowest number you find and the highest number create the range, and obviously you should choose the lower number to reduce your taxes. Also, save or print a screenshot of the salary and information you are basing your reasonable salary on, in case of an audit.
With the knowledge of what a reasonable salary is, you will know at what point your taxes are going to be reduced. If your reasonable salary is $50,000 then all income you earn up to that amount is subject to self-employment tax rates. All income earned above that amount can be treated as a distribution and will not be subject to the 15.3% tax.
Choosing your business structure has a major effect on how much your earnings will be reduced by taxes. Deciding on the right structure, complying with formalities to create your business entity, and filling out a tax return that you've never seen before can add unnecessary stress to your already busy schedule. If you have any questions along the way, or just want to lighten your work load, please contact me. I'm here to help.