Entity Selection: More than Just Tax Rates

Businesses can choose their legal structure, which impacts their taxes. In light of current tax rules as well as the proposed Tax Reform Act of 2014 and the President's budget proposals, which entity is best for you? There's probably no set answer, but there are tax factors you should consider.

Entity selection's impact on employment taxes
Employees pay FICA tax on salary and other taxable compensation, and their corporations match the tax. Sole proprietors, partners, and members in limited liability companies (LLCs) -- all of whom are self-employed -- pay a self-employment tax on net earnings from self-employment. The amount of the tax is essentially equal to the employer and employee share of income. The term net earnings from self-employment is a fancy term for a self-employed individual's share of the business's profits.
 
Take this example: Say an S corporation owned by one person has profits of $200,000 for the year, half of which is distributed as salary. The shareholder-employee pays FICA tax on $100,000 and the corporation does the same. The owner also pays income tax on her $100,000 salary plus the $100,000 that is counted as the corporation's net profits (the corporation subtracts the salary to arrive at its net profits). In contrast, a one-member LLC pays self-employment tax on $200,000 (for 2014 only the first $117,000 is subject to the Social Security portion of the tax, but all is subject to the Medicare portion) and $200,000 for income tax. Thus, for income tax purposes, the results are about the same, but for employment tax purposes, there is considerable savings in the corporate situation.
 
The additional 0.9% Medicare tax. This tax applies to earned income over a threshold amount that depends on your filing status. Earned income means salary and other taxable compensation as well as net earnings from self-employment. Corporate owners pay the tax only on their W-2 income; self-employed individuals pay it on their net earnings from self-employment (all of the net profits allocated to them).
 
Caution: There have been proposals to treat S corporation shareholders like partners for purposes of employment taxes, which would mean they would have the same exposure for self-employment tax and the additional Medicare tax on their share of corporate profits. The Ways and Means Committee proposals (in the link above) do not advocate this tax regime.

Entity selection's impact on audit exposure

Each year the IRS releases its audit statistics showing the number of examinations conducted and on whom. According to these numbers, sole proprietors, particularly those with business income over $200,000, have the highest audit risk. (One-member LLCs are treated as disregarded entities and file the same Schedule C as sole proprietors, so they have the same audit risk.) While changing entities solely to lower audit risk may not make sense, it is certainly a factor that could prompt a freelancer, independent contractor, or solopreneur to incorporate.
 
Deducting out-of-pocket business expenses
Your company may not cover all of the business expenses you pay for. How you write-off these business expenses depends on your entity:
  • Corporations. Shareholders can only deduct their expenses as unreimbursed employee business expenses on Schedule A. This means only amounts in excess of 2% of adjusted gross income become deductible and other limits on miscellaneous itemized deductions apply.
  • Sole proprietors. These business people and their companies are one and the same; there are no unreimbursed expenses. All deductible items are reported on Schedule C.
  • Partners and LLC members. Out-of-pocket business expenses that owners are required to pay for personally are an offset to business income because they are subtracted on Schedule E. There are no separate limitations on these deductions as there are on business deductions claimed on Schedule A.
Conclusion
The decision about entity selection is highly complex. Only tax issues have been discussed here. Other considerations:
  • Personal liability protection, which can be obtained through incorporation or with an LLC
  • State tax issues

Work with a knowledgeable tax advisor when starting a business or when thinking about making a change in entity.

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