Tax planning needs to start at the very beginning of the startup process and continue though the life cycle of the business. Dennis Zink and Bert Seither, VP at 1800Accountant, discuss the decisions that need to be made in order to have a tax strategy that keeps your tax bill low – and legal!
Published: Monday, August 3, 2015.
It’s not how much you make, it’s how much you keep. Sure, we all have to pay taxes and die. Let’s discuss the former, which is a comparatively more pleasant issue than the latter. I recently interviewed Bert Seither, a vice president with 1 800 Accountant. We discussed tax strategies and structuring a business in order to pay less in taxes. He is not an attorney and is not offering legal opinions, by the way.
Q: Why should taxes be a concern for small business owners?
A: Eight or nine out of 10 people in the United States pay more in taxes (annually) than any other expense, often more than mortgage payments, rent, food, insurance and groceries. The question should be not how much money am I making but how much money am I actually keeping? Over the years, I’ve found many people do not initially think that way when they’re starting a business. After they’ve been in business a while, they realize they’re stroking checks to Uncle Sam. Then it’s time to do something.
Q: Different forms of businesses will inevitably lead to different tax structures. What type of legal structures or entities should a new business owner consider?
A: There are a lot of options. Initially, I found that a lot of people end up doing nothing at first, meaning they’re a sole proprietorship by default. It’s probably easiest to do nothing and get started in running a business.
Q: In the long run, couldn’t this end up being a more-costly option?
A: It doesn’t cost anything to set up a sole proprietorship. But as a sole proprietorship, your taxes can get extremely high, depending on what state you’re in. You may have state income and federal income taxes. You also have self-employment tax on top of that, which is currently levied at 15.3 percent. It can leave you scratching your head at the end of the year, asking, “What happened to all my money?” when you’re paying 30, 40 percent or maybe even higher in taxes.
Q: What are some of the better options?
A: LLC’s tend to be a common choice with business owners today; S Corporations, as well, especially for small businesses. There’s really not a one-size-fits-all approach. Definitely get some legal and tax advice when deciding what entity to set up. The LLC is a flexible entity, because it’s got the least amount of paperwork involved. You’re not required to have corporate minutes and meetings as you would with a corporation.
Q: Isn’t the LLC known as a hybrid entity?
A: It’s a cross between a sole proprietorship and a corporation. An LLC does not come with an inherent tax structure. You don’t choose at the end of the year, when it’s time to file your LLC’s taxes, you choose in the beginning. This selection has to be done within 75 days of forming your LLC. You do this by making what’s called an entity classification election.
Q: Does the entity election occur once, or could you change the tax structure of your LLC during the existence of the LLC?
A: You can change, but once you pick something, you have to stick with it for five years. If you’ve missed that 75-day window, which a lot of people do (because they didn’t know they had an option), there’s a revenue procedure that can be used to change it between Jan. 1 and March 15 of the following year. It is very common to see an LLC making an entity classification election to be taxed as an S Corporation.
Q: Does that mean that you’re actually setting up an S Corporation?
A: You’re always an LLC. You have the phenomenal benefits of asset protection, limited liability, et cetera, but you can get the tax benefits of a corporation. It’s all about the reduction of self-employment taxes. The S Corporation is another common structure because it is a pass-through structure, meaning you’re not having to deal with the double taxation of a C Corporation. With the S Corporation, there are basically two ways to take money out of the business.
Q: What are the two ways?
A: You have to pay yourself what’s known as a “fair and reasonable salary.” Even if it is a oneowner S Corporation, you would be an employee of your company and have a W-2 from your company at year-end. Your company is paying half those taxes for you, which is a deduction for the company. Then you pay the other portion. About 50 percent can be distributed to you via a K-1 form. The beautiful thing about this is there are no self-employment taxes on money distributed via a K-1.
Q: If you have an S Corporation or an LLC taxed like an S Corporation, it appears that you can reduce your self-employment taxes by about half?
A: Let’s say you had a profit of $100,000 in your business. You were a sole proprietorship and you didn’t do anything. Self-employment tax, at 15.3 percent, times $100,000, is $15,300. If you have an LLC and you tax it like a corporation, an S Corp, or if you have an S Corporation, you could take some of the money out as a salary.
Call it $50,000 as a salary. The other $50,000 is distributed to you. There are no selfemployment taxes on the distributions because it’s through the K-1. In this example, you cut your self-employment taxes in half, so you’re saving over $7,000.
The bottom line is a little bit of paperwork and a little bit of understanding and proper structuring in the beginning can actually save a significant amount of money. I like to use the old truism, “Don’t trip over pennies to get to dollars.”
Q: If you had an LLC, you could also choose to have it taxed as a partnership. What is the effect of doing this?
A: That would be true if you have a partner. If it’s a single-member LLC, it’s defaulted to a Schedule C. If it’s a multi-member LLC, it’s defaulted to a 1065. In essence, then, it’s treated taxwise the same. If you have a partner, you can still elect to tax it like a corporation to reduce those self-employment taxes.
Bert, enough about taxes, let’s talk about death so we won’t feel so bad about taxes.