Taxes: Deciding on a Business Structure Helps Determine Your Profit

Do you know the various types of business structures?
Do you know the manner in which each business structure is taxed?
Do you know that the business structure will determine how much profit you keep?

How you do business is as important as what your business does.
Wealthy business owners spend valuable time deciding on a business structure first.

Let’s begin with a short primer on the various ways in which you can operate your business activity. We will highlight the following ways and then go into detail on how each is taxed. This is critical that your profits will be the subject and target of the tax laws depending upon how you operate your business, and it will determine how much or how little you keep of your profits.

Business Structures

A business structure is a term that describes how a business is organized for legal and tax purposes. The focus of this article is primarily to provide insight into the significant value of understanding that one of your most important business decisions will be to decide how you will do business.

Deciding on this business structure helps determine if your business will be financially successful based on how much of your profit you will keep.

The various business structures are:

Sole proprietorship (Self-employed)
Single Member Limited Liability Company (LLC)
Husband and wife (Self-employed)
Multiple Member Limited Liability Company (LLC)
General Partnership
Limited Partnership
“C” Corporation
“S” Corporation

Each of the business structures determines among other things how you, the owner, will be taxed by the IRS and by your respective state. Many wealthy businessmen and women spend a good amount of time before launching a new venture on how the business will be structured primarily because of how it will be taxed.

Sole proprietorship (Self-employed)

When you do business as a self-employed individual, you place your profits at the greatest risk of being taxed at the highest level possible in a variety of ways that could, in effect, limit a significant amount of your profits from being available to you.

You have three levels of tax when you do business as a self-employed individual. First, you have the self-employment taxes on every direct dollar of profit. This tax is the Social Security Tax (FICA and Medicare), and you are taxed at a rate of 15.3% on the first $118,700 in profits, then 3.9% on every dollar of profit thereafter with no limit on the dollars that will be taxed.

You then take the profits on Line 12 of your Form 1040 and subtract deductions (itemized or standard) and exemption credits (you and dependents), leaving you with taxable income, and then it is again taxed at your marginal tax rate between 15% and 39.6% depending upon how much taxable income you make in that tax year.

You then add an additional 3.9% Obama tax on certain amounts over the threshold income levels and, in effect, you could be paying 15.3% plus 39.6% plus an additional 3.9% federal tax, or 58.8% NOT including state taxes such as up to 11% in California.

Single Member Limited Liability Company (LLC)

A Single Member LLC is disregarded for federal tax purposes and in effect is taxed exactly as if you were self-employed sole proprietorship (Self-employed).

The real problem here is that in some states, like California, you could also be subject to an LLC entity tax based on “Gross Receipts,” not net profits of the LLC, so that when you really review the tax impacts of the business, you could have as much as 60% going to tax!

Husband and wife (Self-employed)

In this situation, the federal tax rules require that both spouses file a “partnership” tax return unless they make a special tax election to be taxed as a marital joint venture (or MJV), in which case an MJV files 1 Schedule C for the business. On the other hand, a partnership files a Form 1065 Return, and each spouse is taxed at the self-employed tax rates on their equally divided share of the profits.

In effect, both spouses now have a $118,700.00 limit that is subject to the full 15.3% SE tax instead of the single Schedule C under the MJV, where the profits are not divided between the spouses so that only the first $118,700.00 in profits is subject to the SE tax.

Multiple Member Limited Liability Company (MMLLC)

In this situation, unless the LLC elects to be taxed as a corporation, then it will again be taxed under the partnership tax rules so that, in effect, each partner is subject to the SE taxes of 15.3% on the first $118,700 in profits each partner received (or guaranteed payments to each partner by the partnership).

Any LLC entity can make an election to be taxed as a corporation, and then it will be taxed as a “C” corporation unless it makes a further election to be taxed as an “S” corporation. The other tax problems with the MMLLC is that under partnership tax rules, many transactions between the partnership business and each of its partners has with it a host of tax traps that in effect could result in higher tax impacts overall.

General Partnership

In this case, two or more parties join together in a partnership agreement to conduct business. Then, capital contributed to the business by each partner is booked, and the profits or losses are allocated among the partners according to the percentage they each own of the shares of the partnership. Again, payments to each partner from profits will be taxed as if the partners are each self-employed, so again we face higher levels of tax exposure in a partnership.

Losses are limited in some cases based on the capital account of each partner, as you may not deduct those losses if they are more than your basis in the shares you own in the partnership. If you contribute $10,000 in capital own 50% of the partnership and have $60,000 in loss, then you can only deduct $10,000 of your half of the $60,000 in loss, and the remaining loss is suspended and carries forward into the next year.

Limited Partnership

In this case, there is no SE tax as you are not active in the business; however, any loss in the business is limited under the Passive Activity Loss (PAL) rules, so there is a definite restriction on how much you will be able to claim. But then, in this case, you really aren’t in business, either, are you?

“C” Corporation

Every corporation begins when formed as a typical “C” regular corporation (and then makes an election to be taxed as an “S” corporation; see the next section). A “C” corporation shareholder is taxed twice, once at the corporate tax rates, which are graduated based on tiered levels of profits to a maximum of 39%, and then a second time when those profits (dividends) are paid to the shareholder/owner at his or her personal tax rates on the personal Form 1040 return. In effect, the company is double taxed on the same profits, and the dividend paid to the shareholder is not a deduction for the “C” corporation.

“S” Corporation

An “S” corporation refers to Sub-Chapter S of the Internal Revenue Code and the profits pass-through the corporation with no tax at the corporate level. They are taxed at the personal tax return level of each shareholder of the “S” corporation. The trap here is that if the shareholder is active in the business of the corporation, then the tax laws require you to be paid a wage and tax it as taxable wages on a W2, thus invoking all the FICA, Medicare, FUTA, SUTA, and employer matching of FICA and Medicare tax. Moreover, the wages (salary and compensation) must be reasonable (not unreasonably high or low), and for many types of payments to its shareholders, the “S” corporation must use partnership tax laws in deciding the level of tax owed by the shareholder.

Summary of Tax Impacts

Before you launch the GREAT business idea for the future, you must decide HOW you will do business if you ever hope to financially survive and prosper.

In these various forms of tax impacts, based on the manner in which you decide to conduct business, you also can, like many wealthy business owners, formulate combinations of business structures to conduct business and as a result seriously reduce the tax impacts as well. For example, a partnership can have partners who are Single Member LLCs and, in that structure, can be owned by a corporation so that you have a matrix structure that is designed to preserve and protect your wealth. The benefit is that if it’s properly organized, you will almost always pay less in taxes than with planning.

In my more than 30 years in practice and as an enrolled agent and specialist in business organizational planning and reorganization planning, every client I have represented or advised understood the value of planning and taking time to map out and understand how it is they will be taxed when the business launch takes place.

My advice and suggestion is after you decide what your business will do, stop and decide how it will be taxed when it does it. This single decision could in many cases decide your financial success.

James Harnsberger is an Enrolled Agent admitted to practice before the IRS, an NTPI Fellow, a credentialed paralegal in tax law, and a champion of IRS reforms. He provides laser-focused tax planning strategies and advice to individuals and business owners. James provides an aggressive posture in defending taxpayers before the IRS and has been in practice over 30 years. An exceptional public speaker and a very tough advocate for his clients, James is also founder and CEO of the WEALTH & TAX GURU Coaching Program, a wealth transformation personal coaching program he developed to help empower every American in their financial life. The Wealth Coaching Program provides an entire Wealth Transformation Coaching model that will transform your financial life.