All businesses want to lower the amount of tax they pay. So, how do you actually do that? The team here at Evolution Tax & Legal is here to help you understand all the goes into tax planning for businesses.
We have worked with large companies, with the likes of those in the fortune 500, to smaller local mom and pop shops to help them arrange and plan their business affairs to lower taxes in future years.
To help you understand the basics behind tax planning for your business, we have put together some items you should be considering when planning to mitigate your taxes and choosing the type of entity to run your business through for maximum tax savings.
In this article, we discuss the basic considerations and tax planning opportunities applicable to —
· C Corporations
· S Corporations
· Sole Proprietorships and Disregarded Entities
What To Consider for Your Tax Reduction Strategy
There are many taxes applicable to the operations of a business. The Orange County business formation lawyers at Evolution Tax and Legal will help you create a tax planning strategy and work through the following types of taxes—
· Business income taxes, depending on your business legal form.
· State and local income taxes, depending on your business location.
· Business licenses and permits, depending on your business location and business type.
· Employment taxes. While most employment taxes are federal, states may have different employment tax costs.
· Self-employment taxes can be higher or lower, depending on your total business income and QBI deduction.
Each of these types of taxes has its own set of rules and nuances to be considered and a tax professional on our team can help plan for and mitigate each type in a wholistic manner.
How to Choose a Business Entity
The first thing to consider when starting a business is the type of entity you are going to operate through.
This choice has both legal liability and tax implications. These generally consist of corporations, general and limited partnerships, and LLCs. Each type of business entity has its own specific operating structure as imposed by state law, and each type provides a varying degree of protection to their owners.
These general entities that a business should consider the benefits and burdens of, are C Corporations, Partnerships, S Corporations, and a Disregarded Entities. Each of these tax entities is subject to its own set of rules and regulations as to how taxable income is ultimately calculated under tax law. Some entities are more advantageous than others depending on the businesses operating structure and ultimate goals. At Evolution Tax & Legal, we can help you understand the tax benefit and tax burden associated with each of these entities when crafting a tax plan for your business.
To put it simply, a C corporation is treated as a separate and distinct entity from its owners. It must calculate its own income and loss and is obligated to pay tax on its own income. No income earned by the C corporation is reportable by its owners unless it makes a distribution to them in the form of a dividend.
The taxable income of a C corporation is subject to a flat 21% rate. The taxable income of a C corporation is calculated similarly to that of an individual (gross income minus allowable itemized deductions) but is subject to its own set of restrictions and exceptions under tax law.
While the 21% federal rate is lower than the top marginal rate of an individual (currently at 37%), this is somewhat of a misnomer. Once the income of a C corporation is subject to tax at 21%, and thereafter distributed to its owners in the form of a dividend, its owners must pay tax on said income again. Thus, the income of a C corporation is subject to two layers of tax when ultimately returned to its owners. This dual-layer of taxation is an inefficient method of taxation on income earned by a partnership or an S corporation which is taxed in a “flow-through” manner.
This is a very high-level overview of the tax implications of operating a C corporation. There are many more considerations than those mentioned above, and an experienced tax lawyer should be consulted before ultimately choosing the entity to conduct your business through.
At the least, the tax consequences of a C corporation should be contrasted with that of a flow-through entity, such as those discussed below.
Partnerships—better known as the quintessential “pass-through” entity. The general tax treatment of a partnership is exactly as it sounds—the income, gain, deductions, and losses pass through the partnership entity and are reported on the income tax returns of its partners. Thus, the partnership is generally not seen as a separate and distinct entity from its owners, but rather as an extension of them.
For example, assume Partnership A has four partners. Each partner holds an equivalent 25% share of the partnership’s profit and loss. If Partnership A has $100 of taxable income in a given year, each partner will have to report their 25% share of such income on their tax filing. Thus, each partner would have to report $25 dollars of income from the partnership on their own tax return.
Due to the flow-through treatment of a partnership, the tax filing of a partnership (i.e. Form 1065) is generally seen as an informational filing to report to the IRS what the total operations of the partnership was and what each partner’s share of such income or loss will be in a given year. The partnership itself is generally not subject to tax, but rather its individual’s partners are responsible for paying such tax. This is very unlike a C corporation which is responsible for reporting and paying the tax due on the income the C corporation generates in a given tax year.
The flow-through nature of the partnership prevents the incidence of double taxation as you normally see in a C corporation. This is because the income flows through the partnership and is ultimately reportable on its partner’s income tax filing. Thus, only the partner is responsible for reporting their share of the partnership’s income and paying tax on such income.
Just as a warning for the wary, these general tax consequences are just that—partnerships are the most complex entity to account for in the tax code and subject to very complex nuances. What we have not covered is the impact of liabilities held by the partnership, contributions and distributions of certain
property within two and seven-year periods, etc., all of which are subject to very special provisions and could trigger massive tax liabilities.
With that being said, partnerships offer the most amount of flexibility to its owners and prevent the imposition of two layers of tax. Not to mention, the most recent tax reform, formally known as the Tax Cuts and Jobs Act (“TCJA”), passed a very favorable provisions for owners of qualifying pass-through owners that provide a 20% deduction to the income that is passed through to them. This provision in contained in IRC 199A, and is informally known as the Qualified Business Income Deduction (QBI deduction). In combination with this deduction, income earned and passed through to the partnership’s ultimate owners is subject to an effective tax rate of 29% on their income from partnerships.
An S Corporation brings together the worlds of corporations and partnerships. The quintessential line about S corporations is that it provides the benefits of the partnership’s “flow-through” treatment while providing the protection and organization hierarchy that a corporation can provide. One of the major differences between an S corporation and a C corporation or a partnership is the myriad of restrictions on ownership, which is why S corporation is representative of the term “small corporation”.
The restrictions on an S corporation’s ownership are as follows—
· Shareholders can only consist of individual, certain trusts, estates, and certain tax-exempt organizations;
· All shareholders must be US citizens or residents;
· There is a maximum of 100 shareholders
· Only one class of stock is allowed;
· Profits and loss must be allocated proportionately amongst all shareholders;
· All shareholders must consent to the election to be treated as an S corporation; and
· The business cannot be an “ineligible corporation” such as an insurance company or a domestic international sales corporation.
In addition to the differences in ownership requirements above, the ownership requirement varies from that of a partnership as an S corporation does not require two or more people to operate. An S corporation can be owned and operated by a single person. Generally, you will see an S corporation used by a sole proprietor to avoid or lessen the impact of self-employment taxes as outlined below.
So, once you decide that you want to operate in the S corporation format, how do you form it? Well, it’s through the form of an election filed with the IRS on IRS Form 2553. For all new entities formed, an S corporation election must be filed within two months and fifteen days of the date of the entity’s formation to take effect for the first tax year. For existing businesses, the election must be made within a similar timeline in order to take effect for a given tax year. If the election is filed late, there is a late election filing procedure put out by the IRS that will allow the late filing of such an election without the incurrence of a penalty. Please note that there are very complex rules to account for the conversion of an existing business to an S corporation.
In addition to the flow-through benefits provided by the S corporation structure, it also provides taxpayers relief on payroll and self-employment taxes. Generally, income earned by a self-employed person is subject to a total of 15.3% of Social Security, Medicate, and self-employment taxes on all profits earned. However, with the use of an S-corporation, the amount that is not paid to the S corporation’s owner(s) in the form of a salary is not subject to such taxes.
However, if the sole proprietor instead operated through an S corporation, this tax amount would changes. Before continuing with the example, there is a concept applicable to S corporation owners and operators that imposes a requirement to pay themselves a “reasonable salary”. This amount of salary is subject to the 15.3% of self-employment taxes, while the remainder flows through to the S corporation owner exempt of the 15.3% in self-employment taxes.
The final structure that we will discuss here is that of the disregarded entity. Just as the name infers, the entity is disregarded for tax purposes and is treated as if it does not exist.
All of the income, gains, expenses, and losses are reported directly on the return of the disregarded entity’s owner. The entity itself is not responsible to make any tax filings and to pay any taxes due.
Generally, a disregarded entity structure will be found when there is a single individual owner of a state limited liability entity such as an LLC who does not wish to operate a sole proprietorship in either the C corporation or S corporation format but needs the protection against potential lawsuits or other liabilities borne by the entity.
As outlined above, a disregarded entity is not advantageous when it comes to calculating self-employment taxes in comparison to that of an S-corporation. The owner of the disregarded entity (if an individual) will have to report all income as earned from self-employment, and be subjected to the full 15.3% of self-employment taxes due on such income.
However, disregarded entities are widely used by corporations or partnership to provide themselves state limited liability protection when operating in certain states. For example, you will see this in the context of real estate when a company purchases and operates rental real estate in a specific state. The business will form a limited liability company (LLC) to hold ownership of the property to protect themselves from any potential suit, but choose to have the entity treated as disregarded from its parent entity so the activity is directly reported on its tax return.
It, as a small business owner, you still have questions regarding tax planning for businesses or would like to learn more about business tax planning strategies and discuss a tax strategy specific to your company, reach out to a tax professional at Evolution Tax & Legal today.