As entrepreneurs embarking in a business venture, our efforts are primarily focused on taking our new business off the ground with upmost success.  We focus on marketing, projected sales, budgeting, logistics...you get it. What a lot of us neglect to do is map out a properly tax strategy to meet our business needs. Working together with a tax professional that focuses on tax planning is key to maximize our hard-earned income.

As part of tax planning, we have to our advantage certain tax status elections to help us minimize future tax liability since the legal status of an entity at state level and how the entity could be treated for tax purposes could differ. Time-sensitive election of the appropriate tax status for your business type help save thousands of dollars in tax liability.

Legal Entities and Applicable Tax Elections

There are three general entity categories that can be legally formed at the state level.

These are:

Sole Proprietorship

Limited Liability Company

Corporation

Sole Proprietorship – Sole Proprietorship is the most basic type of entity. As a sole proprietor you can use a Doing Business As name and it is considered a disregarded entity. Owners report revenue and expenses through their Individual Tax Return From 1040 Schedule C and the net profits of the business are used to calculate applicable self-employment tax.

Limited Liability Company- A limited liability could be legally formed as a Single-Member LLC or Multi-Member LLC. Depending on state regulations, a Professional Limited Liability Corporation might be the required LLC for state licensed service providers. One of the benefits of an LLC is that it offers a level of protection against personal assets and it is one of the most popular entity formation due to potential high tax savings.

At the tax level, a Single-Member LLC can elect to file as a Sole Proprietorship or as an S Corporation.

A Multi-Member LLC can elect to file as a Partnership or as an S Corporation for tax purposes.

Corporation – A corporation, or otherwise known as a Professional Association, can elect to be treated as a C Corporation or an S Corporation for tax purposes.

IS AN S CORPORATION THE RIGHT ELECTION FOR MY BUSINESS?

The S Corporation election, when properly planned, is a fantastic tax saving strategy for small business owners. Proper planning of the use of an S Corporation would help dramatically reduce self-employment tax liability.

But beware, there are circumstances when electing to be taxed as an S Corporation is just not smart and might cost you more.

Here are some of the most common scenarios to consider:

How the state or city where the entity is formed taxes S corporations? Some states do not recognize the S Corporation election. These states tend to tax either the revenue or the business yearly profit at a very high tax rate. Some of these states or cities are District of Columbia, New Hampshire, New York City, Tennessee, and Texas.

Other states, such as Louisiana, tax the S Corporation as a C Corporation but allows exclusion regarding the portion of income to which Louisiana shareholders pay income tax. Alabama, for example, imposes a business privilege tax on the S Corporation’s net worth.

In California, an S Corporation must pay the greater of $800 minimum tax or a 1.5% corporate franchise tax on income.

These are only a few of the different treatments per state that must be taking in consideration. Before establishing any business entity, we encourage you to seek legal advice in your state.

W-2 Income If you are a high-wage earner via W-2 and your wages exceed the wage base applicable to Social Security and Medicare, you probable would not benefit from electing to be treated as an S Corporation until your net profits reaches a considerable amount. A premature election could cause you to lose money on the employer portion of Social Security and Medicare.

Low Business Profits or Below Recommended Level A premature S Corporation election could cost you more in the long run due to the various costs to operate the business such as payroll preparation fees and quarterly and annual tax filing requirements.

Passive Income If your business generate passive income such as a partnership whose main activity is rental income, electing an S Corporation is not only inappropriate but costly. As an S Corporation the rental income would be subject to self-employment tax when in reality only what the IRS classifies as general income is subject to Social Security and Medicare.

 

Book a tax planning consultation today at contactus@expatworldwidetax.com. We’ll be happy to help!