As I’ve discussed in previous posts, business owners should choose to form a limited liability entity. While it is true that businesses can opt to be sole proprietorships or general partnerships, those entities do not limit personal liability and subject you to being personally liable for debts of the business.
WHICH LIMITED LIABILTY ENTITY SHOULD I CHOOSE?
The two primary limited liability entities in Ohio are the Limited Liability Company (“LLC”) and the corporation. There are many distinctions between the two types of entities, and each has different requirements for remaining in good standing under the law, however business owners getting started generally care most about their bottom dollar. Therefore, taxation is often the most important distinction between the LLC and the Corporation. To simplify, corporations are taxed twice, and LLCs are taxed once. Below, I explain in more detail how this works.
C Corp Taxation
When corporations earn a profit, they are taxed under the corporate tax rate. With the passage of the Tax Cuts & Jobs Act of 2018, corporate profits are taxed by the government at a flat rate of 21%. However, corporate profits are taxed a second time as income when they are distributed to the shareholders as dividends. Most dividends are considered ordinary dividends and are taxed as ordinary income. In some instances, dividends can be considered qualified dividends, which are only subject to capital gains taxes.
For example, if a two-shareholder corporation earns $100,000 in profits the corporation itself will be taxed a 21% tax of $21,000. If the corporation then distributes the remaining $79,000 equally between the two shareholders, then each shareholder pays income taxes on their share.
While LLCs can elect to be taxes as a corporation, most LLCs are taxed as a partnership. Under this method of taxation, profits and losses are passed directly to the owners; the entity itself does not pay taxes on income. This is referred to as “pass through taxation.” Each member of the LLC pays taxes on their distributive share on income. For example, if a two-member LLC earns $100,000 profit and each member owns 50% of the company, each member will pay income taxes on $50,000 of those profits.
S Corp Taxation
The LLC form of taxation is not the only form of pass-through taxation. The small business corporation, or S Corp, is another pass-through tax election that can be made by both a corporation or an LLC. But, when should an LLC elect to be taxed as an S Corp.?
Electing to be taxed as an S Corp can allow shareholders/members to avoid some self-employment taxes. Apart from other taxes, entrepreneurs are also taxed a 15.3% flat tax called a self-employment tax. The self-employment tax covers those federal government taxes, such as Medicare and social security taxes, that you pay if you are employed by someone else. In an employer-employee relationship, the 15.3% tax is split evenly between the employer and the employee. In a self-employment situation, the entrepreneur is hit with the entire 15.3% tax.
However, the S Corp tax election can allow the owners to avoid some of these self-employment taxes! This is because payments made to the shareholders as a dividend are not considered self-employment earnings. Thus, a shareholder of an S Corp who is participating in the business can, to a certain extent, avoid a significant amount of payroll taxes by dividing the shareholder’s income reasonably between compensation payments (self-employment income) and dividends (not self-employment income). The catch: the law requires the S Corp shareholder who is participating in the business to receive a reasonable salary, commensurate with the work being performed.
Example: imagine that two veterinarians open their own vet clinic using an LLC and they decide to have the LLC taxed as an S Corp in order to save on some self-employment taxes. Let’s assume for this example that a full-time veterinarian makes, on average, $100,000 per year. The veterinarians cannot simply pay themselves what is clearly not a salary commensurate with their work, i.e., they cannot pay themselves $30,000 per year because it is obviously inadequate. Let’s assume that the veterinarian clinic made $400,000 in profits and each veterinarian received $100,000 in salary. Self-employment taxes would be assessed on $200,000. The remaining $200,000 in profits could be distributed to the veterinarians as dividends. Therefore, $200,000 will not be subject to the 15.3% self-employment tax, thereby saving the veterinarian $30,600. If the LLC was paying taxes as a regular LLC, the entire $400,000 would be subject to self-employment taxes.
Still, there are some limitations to electing to be taxed as an S Corp, including the types of shares the S Corp may issue and who can own those shares. As always, there are other factors, aside from taxation, that are relevant to entity selection. For example, if you are a business that aims to seek funding, a corporation may be the best entity selection for you.
Contact Wick Law, LLC to discuss the goals you have for your business and we can help you assess what entity would be best for your particular situation.
Wick Law, LLC is a small business legal practice, representing owners, investors, and entrepreneurs in all aspects of commercial, corporate, and business law, estate planning, contracts and negotiations, business litigation, and real estate. For more information: Contact 614-572-6366, visit www.mwicklaw.com, or email us at firstname.lastname@example.org. Wick Law, LLC is located in Columbus, Ohio.
(Materials in this article have been prepared by Wick Law, LLC for general informational purposes only. This list is for educational purposes and is not to be considered exhaustive. More items could be added to this checklist based upon the type of transaction or industry standards. These materials do not, and are not intended to, constitute legal advice. The information provided is not privileged and does not create an attorney-client relationship with Wick Law, LLC or any of the firm’s lawyers. This checklist is not an offer to represent you. You should not act, or refrain from acting, based upon any information in this checklist. Wick Law, LLC maintains offices in Columbus, Ohio, and has lawyers licensed to practice in Ohio and in the United States District Court, Southern District of Ohio. The firm does not intend to practice law in any jurisdiction where the firm is not licensed.)
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