SMART BUSINESS STRUCTURING: LLCS, S-CORPS, C-CORPS & MORE
When you're starting or restructuring a business, one of the most important decisions is choosing the best type of legal structure for your company. This crucial decision impacts how much you pay in taxes, as well as affects your business paperwork requirements, the personal liability you face and parameters for raising money.
What are some of the common business structures the Business Law Group can choose from to fit my needs?
The most common forms of business structures are sole proprietorships, partnerships (general and limited), corporations, S corporations, limited liability companies, franchises and special forms of business. Because each business form has different tax consequences and affects your personal liability, you can depend on the Business Law Group team to help you choose the entity and structure that best fits your business needs.
LLCS: OUR FAVORITE LOUISIANA ENTITY
There are a number of reasons why our preferred legal entity is an LLC. First, it's an easy business structure to form and administer. Of course, there are some exceptions, especially if you're raising capital from outside investors. But barring this concern, we advise most new entrepreneurs to form an LLC.
Single-member LLCs do have some unique challenges if the owner/member doesn't adhere to some basic corporate formalities. If you fail to follow and document these formalities, creditors could “pierce your corporate veil." This means your business and personal matters aren't separate. To ensure your LLC provides the legal protection you need, it's a good idea to:
- Adopt a single-member operating agreement
- Establish a separate business bank account
- Maintain separate books and records
- File annual reports with the Louisiana Secretary of State
- Generally enter all contracts in your business name, not in your personal capacity.
Our Louisiana LLC entity formation services include:
- Reviewing your business/industry and objectives to determine if an LLC is the right fit for your concept
- Obtaining your company's EIN from the IRS
- Drafting and filing your articles of organization with the State of Louisiana or the Delaware Secretary of State
Drafting your single-member or multi-member operating agreement.
Review our LLC setup costs here.
LLCS TAXED AS S OR C CORPORATIONS
There are a number of reasons why you might choose a business structure hybrid between a corporation and an LLC (limited liability company). Entrepreneurs most often choose this structure for tax purposes. Whenever we create a business entity, it automatically receives a form of tax treatment by default.
A multi-owner LLC is automatically taxed as a partnership by default, while LLCs with one owner are taxed like sole proprietorships, or single-owner businesses. However, LLCs may choose to be taxed as a C corporation or S corporation. We can do this easily by filing a document called an election with the IRS. Once we've done this, as far as the IRS is concerned, your LLC is the same as a corporation, and files the tax forms for that type of entity.
Most LLCs stick with their default form of taxation. But if you elect to be taxed as an S corporation, you can enjoy some tax advantages. This can be especially true as a result of the new pass-through tax deduction created by the Tax Cuts and Jobs Act.
HOW S CORPORATIONS ARE TAXED
Like a partnership, an S corporation is a pass-through entity—income and losses passes through the corporation to its owners' personal tax returns. S corporations also report their income and deductions much like partnerships. An S corporation files an information return (Form 1120S) reporting the corporation's income, deductions, profits, losses and tax credits for the year.
If you have an S corporation, you must provide shareholders with a Schedule K-1, listing their shares of the items on your corporation's Form 1120S. The shareholders file Schedule E with their personal tax returns (Form 1040) showing their share of any corporation income or losses.
Here's where S corporations really differ from partnerships: the employment status of owners who work in the business. If you're the owner of an LLC taxed as a partnership, you're not an employee of the LLC for tax purposes. You're simply a business owner.
In contrast, if you own an S corporation and perform more than minor services for the corporation, you'll be considered both an owner and employee for tax purposes. In effect, any active owner in an S corporation wears at least two hats: as a shareholder (owner) of the entity, and as an employee of that entity.
An owner/employee must be compensated for his or her services with a reasonable salary and any other employee compensation the corporation wants to provide. The owner/employee must report any S corporation's earnings on his or her personal income tax return, and pay his or her share of Social Security and Medicare taxes on any employee salary paid. The corporation must withhold federal income and employment tax from the owner/employee's pay, and pay state and federal unemployment taxes and Social Security and Medicare taxes on the employee's behalf.
The Social Security and Medicare tax rate for an employee is the same as for a self-employed business owner; however, it's paid differently. Half the total tax is deducted by the employer from the employee's pay, and half is paid by the employer itself. When you own the business that's paying these taxes, it makes no practical difference that half is paid by the employer—because you're the employer.
EMPLOYMENT TAX SAVINGS
Being classified as an “S corporation employee” has a potential big advantage: The S corporation tax treatment provides a way to take some money out of your business without paying employment taxes. This happens because you don't have to pay employment tax on distributions (dividends) from your S corporation—that is, on earnings and profits that pass through the corporation to you as an owner, not as an employee in compensation for your services. The larger your distribution, the less employment tax you'll pay. The S corporation is the only business form that makes it possible for its owners to save on Social Security and Medicare taxes. Historically, that's been the main reason S corporations have been popular.
Here's an example: Susan forms an LLC to operate her ecommerce business and elects to have it taxed as an S corporation. Susan is an employee of the LLC and receives a $100,000 yearly salary. The remaining $100,000 of the business's profits pass through the S corporation and are reported as an S corporation distribution on Susan's personal income tax return, not as an employee salary. Because the $100,000 isn't viewed as employee wages, neither Susan nor her corporation need to pay Social Security or Medicare tax on this amount. Susan and her corporation only pay a total of $15,300 in employment taxes (15.3% x $100,000 = $15,300). Had Susan not elected S corporation status for her LLC, she would have had to pay self-employment tax on her entire $200,000 profit. That meant she would have been required to pay an additional $2,900 in Medicare taxes and $1,252 in Social Security taxes.
If you take no salary at all, you wouldn't owe any Social Security and Medicare taxes. As you might expect, however, this isn't allowed. The IRS requires S corporation shareholder-employees to pay themselves a reasonable salary—at least what other businesses pay for similar services. Moreover, due to the pass-through tax deduction (discussed below), it can be advantageous for an S corporation to pay substantial employee salaries.
PASS-THROUGH TAX DEDUCTION
The Tax Cuts and Jobs Act established a brand-new tax deduction for businesses owned through pass-through entities: sole proprietorships, partnerships, LLCs and S corporations. Starting in 2018, owners of such entities may deduct up to 20% of their net business income from their income taxes. This is a personal deduction all pass-through business owners may take whether or not they itemize.
However, you qualify for the 20% deduction only if your total taxable income for the year is less than $157,500 (single) or $315,000 (married, filing jointly). If your taxable income is greater than $207,500 (single) or $415,000 (married), you don't qualify for the pass-through deduction unless your business pays employee wages or has business property. In this event, your deduction is limited to the greater of (1) 50% of the W2 wages you pay employees, or (2) 25% of wages plus 2.5% of the cost of your business property (but the deduction may never exceed 20% of your business income). Here's where an S corporation can help you. As described above, when you elect S corporation status, you work as your business's employee and are paid W2 wages.
These wages can enable you to qualify for the pass-through deduction.
Here's an example: Assume that Susan from the above example earned $500,000 in profit from her ecommerce business, and that her business has no depreciable property. At this income level her pass-through deduction is limited to the greater of (1) 50% of W2 wages paid by the business, or (2) 25% of wages plus 2.5% of the cost of business property. Susan works as an employee of her business and pays herself a salary of $200,000. She qualifies for a pass-through deduction of $100,000 (50% x $200,000 = $100,000). Had Susan not elected S corporation status, her business would have paid no W2 wages to employees and she wouldn't qualify for any pass-through deduction.
Unfortunately, the strategy outlined above doesn't work if you're involved in a personal service business, such as accounting, law, health, consulting, athletics, financial services and brokerage services. The pass-through deduction isn't available for such businesses where the owner's taxable income is over $415,000 for marrieds or $207,500 for singles. The pass-through deduction is gradually phased out for these taxpayers when their taxable income exceeds the $315,000/$157,500 thresholds. This is intended to prevent highly compensated employees who provide personal services—lawyers, for example—from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction.
HOW TO ELECT S CORPORATION STATUS
Here's the thing: No business entity starts out with the S corporation form of taxation. Instead, you must obtain it by filing an election with the IRS. This simply involves filing IRS Form 2553 with the IRS. However, S corporation status is allowed only if:
- The entity has no more than 100 shareholders
- None of the entity's shareholders are nonresident aliens—that is, noncitizens who don't live in the United States
- The entity has only one class of stock—for example, there can't be preferred stock giving some shareholders special rights, and
- None of the entity's shareholders are other corporations or partnerships.
These requirements pose no problem for most small businesses. If you want S corporation status to apply to the entire calendar year, you must file Form 2553 by March 15—the filing is retroactive to January 1.
EASY BUSINESS STARTUP
“Amanda Butler Schley sat down with me when I was developing the early parts of my company. She's relatable, sharp and thorough. Clearly cares about her clients, community and practice. Would recommend!”
– Sally Lindsay, Big Easel Collective
SCHEDULE YOUR CONSULTATION WITH BUSINESS LAW GROUP TODAY
If you're a new entrepreneur or a business owner who wants to make sure you have the right business structure in place, our Business Law Group attorneys (who are also entrepreneurs) look at your unique situation and make our best recommendations. Schedule your consultation with us today so we can give you a roadmap for your course of action forward.