My Personal Finance Journey

Personal finance observation, musing and decisions in a journey toward financial independence by 2020 with at least $3 million.


By Topics

Overall:
0. About (10)
1. My Progress (139)
2. Car & Home (107)
3. Credit (138)
4. Banking (33)
5. Saving (49)
6. Investing (308)
7. Taxes (89)
8. Spending (74)
9. Misc (97)
A. Archive (49)



MONTHLY ARCHIVE

Feb 2014 (3)
Jan 2014 (6)
Jan 2012 (1)
Apr 2011 (1)
Mar 2011 (1)
Feb 2011 (1)
Jan 2011 (1)
Dec 2010 (1)
Oct 2010 (1)
Sep 2010 (1)
Aug 2010 (1)
Jul 2010 (1)
Jun 2010 (1)
May 2010 (1)
Apr 2010 (1)
Mar 2010 (6)
Feb 2010 (2)
Jan 2010 (7)
Dec 2009 (3)
Feb 2009 (4)
Jan 2009 (8)
Dec 2008 (1)
Jun 2008 (2)
May 2008 (2)
Apr 2008 (5)
Feb 2008 (3)
Jan 2008 (15)
Dec 2007 (32)
Nov 2007 (6)
Oct 2007 (8)
Sep 2007 (9)
Aug 2007 (24)
Jul 2007 (2)
Jun 2007 (1)
May 2007 (3)
Apr 2007 (4)
Mar 2007 (4)
Feb 2007 (13)
Jan 2007 (6)
Dec 2006 (3)
Nov 2006 (7)
Oct 2006 (7)
Sep 2006 (6)
Aug 2006 (4)
Jul 2006 (10)
Jun 2006 (1)
May 2006 (3)
Apr 2006 (2)
Mar 2006 (6)
Feb 2006 (6)
Jan 2006 (3)
Dec 2005 (1)
Nov 2005 (9)
Oct 2005 (8)
Sep 2005 (13)
Aug 2005 (25)
Jul 2005 (16)
Jun 2005 (17)
May 2005 (19)
Apr 2005 (20)
Mar 2005 (24)
Feb 2005 (23)
Jan 2005 (36)
Dec 2004 (40)
Nov 2004 (34)
Oct 2004 (17)
Sep 2004 (21)
Aug 2004 (59)
Jul 2004 (37)
Jun 2004 (31)
May 2004 (29)
Apr 2004 (52)
Mar 2004 (49)
Feb 2004 (49)
Jan 2004 (31)
Dec 2003 (48)
Nov 2003 (52)
Oct 2003 (29)
Sep 2003 (8)
Aug 2003 (5)
Jul 2003 (2)
Jun 2003 (2)
May 2003 (5)
Apr 2003 (2)
Mar 2003 (2)
Feb 2003 (3)
Jan 2003 (29)



 

Tax Strategy for Self-Employment Income, Part 8: LLC and S Corporation

Contributed by mm | September 16, 2005 2:57 PM PST

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

This Post Has Received 10 Comments. Share Your Opinions Too.


franklin Commented on September 16, 2005

You missed a number of important facts.

For example, you forgot to mention that when you form an S-corp, any employee-stockholder must take reasonable compensation. You also missed the fact that a member of an LLC can be passive or active, which can cause different tax treatment.

It looks like you are just repeating some words you have read somewhere without fully understand the subject matter.


D-man Commented on September 17, 2005

Its also the case that for an S-Corp, once an employee has taken reasonable compensation, all profit from the company comes to the individual as non-wage based income which means it is not subjected to either social security or medicare taxes.

This means that if you were able to appropriately show that $50,000 dollars was reasonable compensation for your daily duties and there was another $50,000 in profits then you would only pay the social security and medicare tax on the $50,000 of salary income which would save you 15.3% on the remaining $50,000, an extra $7650 dollars.


FatBoy Commented on September 17, 2005

If I'm not mistaken S Corporations can only have US citizen shareholders.

http://www.info-pedia.com/scorporation.html


Caitlin Commented on September 18, 2005

good post...and I was just looking (not very hard admittedly) for the FICA '05 limit on Friday!


mm Commented on September 18, 2005

Good point D-man and Fatboy! I'm adding a paragraph to explain the reasonable compensation strategy.


dman Commented on September 20, 2005

mm,

I am not sure why you believe reasonable compensation is dictated by how much working capital is required to run the business. There are many things that can factor in, most importantly being what it would cost to hire someone to do the daily duties you perform.

As long as you are taking a salary that would be comensurate with what your job as the "employee" would garner in the market I think you could easily show that to be reasonable compensation to the IRS.


Jonathan@MyMoneyBlog Commented on September 25, 2005

This has been a very interesting series, a lot of stuff I hope to learn more about.

I just hope I'll need it, since that means I'd have some self-employment income worth worrying about!


LH2004 Commented on September 27, 2005

To avoid FICA, the best solution is a limited partnership (with, maybe, an S corporation as general partner). Non-guaranteed profits payouts to "limited partners" are automatically exempted from FICA. I would be willing to take the position that an LLC member is a "limited partner," but using a statutory limited partnership is safer.

Note that eliminating FICA taxes will mean reduced social security benefits, which may or may not mean anything to you.


Chriz Commented on September 28, 2005

Fatboy, with all due respect, but you are mistaken. S-Corp shareholders can be citizens or (permanent) residents.

http://www.nolo.com/article.cfm/ObjectID/A30CE890-BBAA-4B8A-AD66A33FA038988B/catID/B491956E-A152-424B-A2342A5861B5EACF/111/182/241/ART/


Jonas M. Grant, Esq. Commented on April 28, 2006

I can't speak to your specific situation, of course, but another benefit of an LLC, S corp, or C corp is reduced IRS tax audit exposure. The accountants I work with in my business law practice tell me that their Schedule C self employed or "side business" clients are getting unwanted scrutiny like never before. This is especially so, it appears, for California taxpayers, those taking the home office deduction, and high-income taxpayers ($100K/yr on a Schedule C is more interesting to the IRS, it seems, that a 'small-fry' corporation making 'only' $100K/yr). Any accountants - or IRS auditors!? - want to agree/disagree?


Add Your Comments










Remember personal information?




(It will take a few moments for your comment to be published. Please do not close the window until then.)


Read More ... 89 Posts In The Same Category










This page was last rebuilt at February 09, 2014 08:20 AM PST. (820 Words)
 

RSS FEED





PERSONAL FINANCE BLOGS I READ

Consumerism Commentary
Get Rich Slowly
My Money Blog
All Financial Matters
The Simple Dollar






.



Copyright 2003-2014, PFBlog.com. All Rights Reserved. (Privacy Policy)