It's tax season -- and with that comes a whole lot of chatter with accountants.
In an effort to submit their taxes on time, avoid penalties and include as many itemized reductions as possible, many entrepreneurs are speaking with their accountant more frequently than at any other time during the year. During this period, questions often arise about financial issues, reducing taxes and determining strategies for keeping more profit in their pockets (and forking over less to Uncle Sam).
As business owners complete taxes, this is an ideal time to consider whether a change in business structure could deliver tax benefits. While there’s no business structure that is right for everyone, there are potential benefits associated with different legal-entity types.
Here are some main factors small-business owners should consider from a tax perspective, when deciding whether their business should operate as an LLC, S corporation or C corporation.
Income-tax liability. Income tax liability includes how businesses are taxed as a result of a taxable event, which is any transaction that has tax consequences.
An LLC is not a separate taxpayer and does not pay dividends -- all the income simply flows through to the owners. Therefore, the double-taxation concept, where the business and owner can be taxed twice on the same income does not apply to an LLC (unless the LLC elected to be taxed as a regular corporation).
Many small corporations choose the S corporation status, which means that the corporation itself does not pay income taxes and double taxation of dividends will not apply. Therefore, the double tax on dividends is rarely a problem for small businesses.
Self-employment taxes. Self-employment taxes are what a small-business owner must pay to fund Medicare and Social Security.
A business that operates as an LLC generally is not a taxpaying entity, and therefore, does not pay Social Security tax or any other employment taxes on the income of the owner. This means that the owner must pay self-employment tax on the individual income tax return. Because all LLC income is passed through to the owners, the business owners will bear the cost of the tax on all the LLC’s income.
Within S and C corporations, owners do not pay self-employment taxes. If they receive income as a salary, then normal payroll and income taxes must be paid -- not self-employment taxes. In these situations business owners pay only the employee-share of Social Security and Medicare taxes on their wages. The corporation pays the employer’s share of these taxes and reduces its income accordingly. This can result in a substantial total tax savings for the owner-employee.
Fringe benefits. Fringe benefits are rewards given to employees for performing the service of the company and can play a crucial role in employee retention and recruiting. These benefits can include paid life insurance, dependent care assistance, group insurance and parking, among other perks. The value of many fringe benefits can be excluded from an employee’s income.
When evaluating fringe benefits, an LLC is able to choose to be taxed as a corporation, and in this way, it can achieve the same benefits enjoyed by corporations. However, for LLC owners the benefits achieved could be small in comparison to the disadvantages of corporate-tax status. For small-business owners who are interested in providing additional tax-free fringe benefits, choosing to form a corporation may be a better option.
At first glance, it may seem that an S or C corporation differs from the LLC when it comes to offering tax-free fringe benefits to its owners. The fact is that the tax-free benefit -- where employees do not pay taxes on these benefits -- only applies to a C corporation. In an S corporation, tax-free fringe benefits are more limited. Any owner who owns two percent or more of an S corporation is treated the same as an LLC owner and generally cannot exclude the value of these benefits from income.
Digging into a year’s worth of expenses and running the numbers on both self-employment and income taxes this season can inspire many entrepreneurs to think: “How can I lower my taxes next year?" While there are many critical factors for business owners to consider when choosing an entity type, closely assessing the pros and cons of each type across income tax liability, self-employment taxes and fringe benefits will help in choosing the most appropriate entity type. Aligning business priorities and understanding the best value for a company based on the variations between an LLC, C corporation and S corporation will lead entrepreneurs to make the right decision and help grow their business. Scheduling a planning conference with your accountant is the first step in tax planning to lower next year’s taxes.