Business entities yield various tax pros, cons

In the last two articles we talked about the legal characteristics of the most common business entities. I hope you’ve already had your double-almond latte this morning because today is the day we talk about the different tax consequences of corporations and limited liability companies, or LLCs.

I am not an expert on tax matters, so I conned my friend, Nicole Tepe, of Rudd and Company, who just happens to be a CPA, into helping me write this article. Please direct any negative feedback to her and leave me alone.

When a new corporation is formed the organizers decide whether the corporation should be treated as a Subchapter S corporation (S-corporation) or a Subchapter C corporation (C-corporation), which are terms invented by our friends at the Internal Revenue Service. The distinction is for tax purposes.

At the risk of over simplifying, a C-corporation pays taxes on its net income, while an S-corporation passes the net income through to the owners of the company, the shareholders, who report the income on their personal tax returns.

Remember our friend Ray Martin? Ray is starting an electrical contracting company named Rayco. Let’s assume Rayco is a C-corporation. In its first year of business Rayco has $150,000 in gross revenues. It spends $50,000 for materials and supplies, pays $40,000 to Ray as salary, and has a net income of $60,000. Rayco will pay approximately $10,000 in income tax on its net income.

What about the $50,000 remaining in the Rayco bank account after taxes? Does Ray have access to these funds? The answer is yes, but the money must be paid to Ray as a “dividend”. Since Ray is the only shareholder he can receive the entire dividend. If, however, there is more than one shareholder, the dividend must be distributed to the shareholders in direct proportion to the stock each owns. Each shareholder then reports the dividend on his income tax return and pays an income tax on it.

If you have heard the phrase “double taxation,” this is it. I think we all agree it is a very stinky concept.

There are many good reasons to form a C-corporation, but given the size of Ray’s business there may be a better alternative for him.

What if Rayco were an S-corporation? Although an S-corporation must file a corporate tax return, it generally will not pay any tax on its net income. Ray earned $40,000 in salary. The company has a net income of $60,000 (after deducting the cost of materials at $50,000, and Ray’s salary at $40,000). Ray must report both the $40,000 in wages and the $60,000 in net income on his personal tax return and pay income taxes on the $100,.000. Ray will pay taxes on the $60,000 whether he takes the money out of the corporation or leaves it in, but in this case the company does not first pay taxes on the profit.

Ray has one other option: forming an LLC. An LLC is taxed in the same manner as an S-corporation — the net income is passed through to the owners, who in this case are called members. A working member may not receive wages as an employee of an LLC. Instead, a member receives a “draw”, which is not deductible by the LLC as a business expense.

In Ray’s situation with the LLC, his net income is actually $100,000 (the $40,000 draw and the remaining $60,000 after expenses). Ray will pay income taxes on the $100,000, just as he will if he forms an S-corporation.

Ready for another bummer? The net income of the LLC is subject to a self-employment tax for the working member. What does that mean? As an employee the government requires that your employer withhold Social Security and Medicare from your paycheck at the rate of 7.65 percent of your gross pay. The employer is also required to pay an additional 7.65% in matching funds out of the employer’s own pocket. A self-employed individual, however, must pay the entire 15.3 percent for Social Security and Medicare taxes, in addition to federal income taxes.

So which entity best fits Ray’s circumstances? With a C-corporation all the money paid to Ray is either double taxed or subject to Social Security and Medicare (as well as other state payroll taxes).

As an LLC all income from the company will be subject to federal income taxes in Ray’s tax bracket, and subject to the self-employment tax of 15.3%.

With an S-corporation the $40,000 salary paid to Ray is subject to Social Security and Medicare (as well as other state payroll) taxes, but the remaining $60,000 is subject only to a federal income tax. For Ray, selecting the S-corporation actually puts about $5,200 more into his pocket, which is just enough to take his lawyer and his accountant to Mexico during spring break.

Although the S-corporation works best for Ray in the situation presented, it may not always be the appropriate choice. An LLC may have worked better for Ray if substantial losses were expected during the first few years of operation. A C-corporation may have been the better fit for providing fringe benefits to the shareholder(s). Or, given a bona fide business purpose, creating more than one legal entity may have been merited to take advantage of the benefits of the different entities.

The business world is a tricky and treacherous place. It is a good idea to get all the help and advice you can from professionals before you jump in and play with the big boys and girls. And if you don’t feel compelled to take them with you to Tahiti after your ship has come in, maybe you could just pay the bill on time.