Business Owner Entity Selection

Choosing the right entity for your business is one of the most critical and often confusing decisions you will face as a business owner. The right entity can provide significant benefits, including liability protection and tax savings, while the wrong choice can result in unnecessary expenses and legal complications. Although there is no universal “do this, not that” directive, understanding some fundamental principles and planning tips can help you navigate this important decision with greater confidence.

Entity Planning Basics

When embarking on the journey of entity planning, it is crucial to recognize that there are two primary facets to consider: liability planning and tax planning. These two aspects, while equally important, do not always intersect directly. For example, an LLC (Limited Liability Company) is often chosen for its liability protection, ensuring that your personal assets are shielded from business debts and claims, provided it is correctly set up and maintained. However, it does not inherently offer tax advantages.

Due to the inherent risks associated with running a business, we generally advise entrepreneurs to establish an LLC as soon as their business is operational and generating a modest yet steady income, such as a few thousand dollars per month. This early step not only secures your liability protection but also lays a solid foundation for future growth and planning.

Tax Planning Options

Navigating the realm of tax planning involves understanding the three primary tax classifications available to businesses:

1. Taxed as a Sole Proprietorship (Sole-Prop)
2. Taxed as an S Corporation (S-Corp)
3. Taxed as a C Corporation (C-Corp)

Think of these options as stages in a progression. Initially, as a new business owner, you might start with being taxed as a Sole Proprietorship. This is often the simplest and most straightforward approach, especially for those just beginning their entrepreneurial journey. However, as your business flourishes and your profits increase—specifically, when you reach the milestone of $100,000 in profit—it becomes advantageous to elect to be taxed as an S-Corp. This transition can offer substantial tax savings, primarily through the reduction of self-employment taxes.

A C-Corp structure, on the other hand, is typically reserved for specific scenarios that we will explore in more detail later. These situations often involve more complex business operations and strategic considerations, where the benefits of a C-Corp outweigh its administrative complexities and potential double taxation issues.

Transitioning from Sole Proprietorship to S-Corp

One of the most significant and common transitions business owners face is moving from an “LLC taxed as a Sole Proprietorship” to an “LLC taxed as an S-Corp.” This transition is pivotal for many businesses as it marks a critical point in their growth trajectory. Let’s delve into an example to illustrate when and why you would make this switch:

• Scenario: Your business earns a net profit of $100,000.
  • As a Sole Proprietorship, you pay self-employment tax (15.3%) on the entire $100,000 profit, resulting in $15,300 in self-employment taxes.
  • As an S-Corp, let’s assume you pay yourself a reasonable salary of $50,000. You pay self-employment tax only on the salary portion, resulting in $7,650 in self-employment taxes. The remaining $50,000 is distributed as dividends, which are not subject to self-employment tax.
  • Total tax savings: $15,300 (Sole Prop) – $7,650 (S-Corp) = $7,650 saved.
• Note: This is a very simple example & the actual tax savings can vary depending on reasonable wage, QBID, & PTET.

Factors to Consider with S-Corps

When contemplating the S-Corp election, it’s essential to consider several additional factors that can impact your decision:

• Pass-Through Entity Tax (PTET): is a state-level tax that applies to certain pass-through entities, including S-Corps and partnerships. It allows these entities to pay state income taxes at the entity level rather than passing the tax liability to individual owners. This can be advantageous because it can circumvent the federal deduction cap on state and local taxes (SALT), which is currently limited to $10,000. By paying state taxes at the entity level, business owners can potentially deduct the full amount of state taxes paid on their federal returns, thus reducing their overall taxable income. This can drive the benefit of an S-Corp even higher if done correctly.
• Qualified Business Income Deduction (QBID): Evaluate how QBID impacts your S-Corp. The QBID, introduced as part of the Tax Cuts and Jobs Act, allows eligible S-Corp owners to deduct up to 20% of their qualified business income, which can result in substantial tax savings. Understanding the nuances of QBID and its application to your S-Corp is crucial for maximizing your tax benefits.

Steps to Elect S-Corp Taxation

Electing S-Corp taxation involves several key steps, each of which must be meticulously followed to ensure compliance and optimize your tax status:

1. Legal Filing: File the necessary forms with the IRS to elect S-Corp status. This typically involves submitting Form 2553, Election by a Small Business Corporation, which must be completed and filed within the appropriate timeframe.

• Typically, this should be filed by March 15th of the year you are ready to “Promote” to S-Corp Status.
• There are ways to backdate this later in the year, which can be important if your business is growing quickly and you are unsure of your level of profitability when you start the year.

1. Set Up Payroll: Establish a payroll system if you do not already have one.

• Reason for Payroll: As an S-Corp, you are required by the IRS to pay yourself a reasonable salary. This salary must be subject to payroll taxes (Social Security and Medicare), similar to any other employee. Establishing a formal payroll system ensures compliance with IRS regulations, helps you accurately calculate and withhold these taxes, and provides documentation of your compensation structure. Failure to pay yourself a reasonable salary can lead to IRS scrutiny and potential penalties.

1. Update Operating Agreements: Ensure your operating agreements reflect the change in tax status. This includes updating your LLC’s operating agreement to specify the S-Corp election and outlining any changes in management, profit distribution, and other pertinent details.

When to Use a C-Corp

While the S-Corp election is a popular choice for many small to mid-sized businesses due to its tax advantages and flexibility, there are specific scenarios where a C-Corp structure might be more beneficial. Understanding when to use a C-Corp can be crucial for businesses with unique needs or growth strategies.

• Large-Scale Growth and Fundraising: If your business plans to raise significant capital through venture capital or public offerings, a C-Corp is often the preferred structure. Investors typically favor C-Corps due to their straightforward equity structure and potential for issuing multiple classes of stock.
• Reinvestment of Profits: C-Corps are beneficial for businesses that intend to reinvest their profits back into the company rather than distributing them to shareholders. This reinvestment can facilitate growth and expansion without the immediate tax burden on shareholders.
• Employee Stock Options: For businesses that plan to offer stock options or ownership stakes to employees, a C-Corp is generally more suitable. The structure allows for easier issuance and management of stock options and other equity-based compensation.
• International Business Considerations: If your business operates internationally or plans to expand globally, a C-Corp can provide more favorable tax treatment and operational flexibility in managing foreign income and tax obligations.

Advanced Entity Considerations

For business owners with more complex structures and multiple entities, advanced entity planning strategies can provide additional benefits and efficiencies:

• Multiple Operational Businesses: It is advisable to avoid having multiple S-Corps within the same family. Instead, consider using LLCs or LLC-Partnerships for each subsidiary business, with the S-Corp as the owner or partner. This approach simplifies management, reduces administrative burdens, and ensures streamlined tax reporting.
• Real Estate Holdings: Do not hold real estate in an S-Corp. Instead, use a separate LLC for real estate investments. This strategy offers enhanced liability protection and more favorable tax treatment for real estate holdings.
  • Typically, we do not hold more than $2 million of equity in any one real estate entity; this reduces exposure in the event something goes wrong.
• Operating Business and Real Estate Ownership: If you own both a business and the real estate it operates from, set up a separate entity for the real estate. Pay rent to this entity and ensure you have a formal lease agreement in place. This arrangement not only provides clear delineation between business operations and real estate investments but also offers potential tax benefits and liability protection.

By carefully considering these factors and following these guidelines, you can make informed decisions about entity selection and maximize both liability protection and tax benefits for your business. Taking the time to plan and structure your business entity correctly from the outset can provide long-term advantages, ensuring your business is well-positioned for growth and success.

Ensuring you have the correct legal structure, tax plan, operating agreements, and wealth strategy associated is comp