Many investors know that corporate profts are usually double-taxed in this country. That is, profits are taxed at corporate level (as "corporate income tax") first, and then again at the shareholder level (as dividend tax or capital gains tax). Similarly, many fear that for the self-employed, forming a company will subject your hard-earned income to double taxation.

This is not necessarily the case. Just like certain publicly-traded companies like REITs (real estate investment trust) are not taxed at the corporate level, self-employed individuals can also form certain business entities without the peril of double taxation.

Two available options are Limited Liability Company (LLC) and Subchapter S corporation (S corporation). In both cases, the formed business is usually considered as a pass-through tax entity, allowing owners to be only taxed at the individual level. For multiple member LLC or S corporations, they are treated as partnership so each member/owner reports its fair share of company income in his/her individual returns. (LLC and S corporation are very close from the tax perspective. Their difference is mainly in restrictions in ownership, subsidiaries, formalities and lifespan. Here is a quick list of the similarities and difference.)

So, what's in it for those who want to save a dollar or two from the self-employment income?

Don't expect too much. Actually, for most of the necessary business expenses, one can deduct them from Schedule C (Profit or Loss from Business) without forming an LLC or S corporation. This includes cost of goods sold, advertising, insurance, rent, supplies, etc.

Contrary to the common belief that the rich can set up companies and use company money to pay whatever expenses, IRS has very specific rules about what can be deducted and what cannot:

"To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary."

(Of course, there are always some gray areas and small business owners certainly have some leeway to expense personal items on company's accounting book, but again, such practices may not withstand IRS's scrutiny.)

The only tax benefit I can think of, in my case, is the income transfer between my wife and me. In the case of LLC (but not S corporation), owners can elect to distribute profits in any way regardless of each's financial interest in the LLC. In that sense, tax strategies can be applied by shifting income to the spouse that will max out the social security tax income cap ($90,000 for 2005) --any $1,000 transfer will save $124 in reduction of self employment tax.

Another tax strategy may be meaningful for some businesses, though not our family's case. That is: as owner-employee, your income as employee (wages, bonus, etc.) is subject to FICA tax but your income as the owner is not. IRS requires that S corporations pay "reasonable compensation" to shareholder-employee "before any non-wage distributions may be made to that shareholder-employee." For some businesses, owner-employees may be able to demonstrate that their reasonable compensation is less than the profit of the company, and in turn take a profitable yet legal arbitrage between job income and business income in the tax return. (It does not apply to my family as our professional service-driven business virtually does not require any working capital, and it is hard to argue that why our reasonable compensation should be less than the total income -- in this case almost the same as profit -- of the company.)

Therefore, it is fair to say LLC and S corporation do not appear as good tax saving opportunities to me, and the only way to justify them is 1) credibility, and 2) limited liability. (Even the latter is not bullet-proof, because people that intentionally uses the limited liability feature to commit a fraud can lose the protection of the company identity. Search "piercing the corporate veil," and there are handful of reports like this on this topic.)

Now we have LLC and S corporation on one hand that virtually do not offer any extra tax benefits, and C corporation on the other hand that will subject the owner to double taxation, is the advice that no tax dollars can be saved by forming a business entity? Not necessarily. We will explore C corporation a bit more and discuss our potential strategies. Keep tuned.

This post is part of the Tax Strategy for Self-Employment Income Series, please also read the rest of the series:

Part 1: The Tax Exposure
Part 2: The Framework
Part 3: The Major Options
Part 4: Individual 401(k) Introduction
Part 5: Individual 401(k) Analysis & Resources
Part 6: SEP IRA and SIMPLE Plans
Part 7: Forms of Doing Business
Part 8: LLC and S Corporation
Part 9: C Corporation
Part 10: The Conclusion