When you start a business, you need to choose an entity type.
However, selecting the right structure makes all the difference.
Why? Because if you make the wrong choice, you could pay more in taxes than you thought possible. Plus, the paperwork might be more complicated than you expected. Unless you’re a certified public accountant (CPA), you need to hire an accountant who knows and understands entity structures and their tax implications.
Keep reading to learn how your entity type can affect your taxes. Choose the one that will meet your needs now and in the future.
If you’ve chosen a single member LLC, you need to understand that you’ll be taxed at the self-employment tax rate of 15% and then ordinary income on top of that.
Typically, the ordinary income is not a burden to you or our company. It’s usually the 15% self-employment tax.
Generally, as an accountant, I suggest that if you’re at the $100,000 profit mark, which would be $15,000 of self-employment tax, you should start thinking about moving your entity to an S corporation. You’ll remain an LLC as an entity but will be taxed as an S corporation.
Here’s an example:
With a single member LLC, you get a reasonable salary—typically the general rule is 60% to 65% of your profits should allow you to be paid on the payroll. So let’s again use the example of $100,000.
So that’s a $60,000 to $65,000 salary for you.
The $35,000 to $40,000 will save you about five grand in self-employment tax, which would be flowing through your entity on a K-1.
The remaining profit after your payroll would flow through at the ordinary income rate. That saves a significant amount of taxes when you’re starting to build a business that’s profitable. So it’s something to consider.
But along with that, you’ll pay for an S corporation return. Those may be anywhere between $750 to $5,000, depending on the size of the entity and the number of transactions and the complication surrounding that S corporation. We would hope for a bit of complication because we want you to be making a lot of money.
From a multi-member LLC, a form 1065 type of client, the income you get and the draws that a single member LLC takes in a multi-member LLC partnership is posted as a guaranteed payment.
Let’s say I’m a partner with someone else.
I take $50,000 in guaranteed payments, draws, or whatever money out of the bank that’s not a W-2 because it’s a 1065 partnership LLC. I would pay tax on that $50,000 as well as whatever percentage of profit or loss I get from the company.
If I take $50,000 and the profit at the end of the year is $200,000, I will pay ordinary income tax on the $100,000.
But wait a minute. I think I have to pay self-employment tax on that, too. I pay self-employment tax on the other $100,000 along with a $50,000 self-employment tax. So I pay $150,000 times 15% of self-employment tax because we are considered members of an LLC.
Now certainly a multi-member LLC can be taxed as an S corporation, in which case people would again get wages, and the flow through income would hit them at an ordinary income rate.
A C corporation is taxed as a corporation, and the individual taxpayer is taxed for their W-2 (wages) unless they’ve taken distributions, which is a whole. That would be at the ordinary income tax rate. But keep in mind that people are not typically forming C corporations these days.
As a small business owner, it’s important to know how an entity type can affect your taxes, so let’s recap.
A single member LLC, multi-member LLC, and S corporation are considered flow-through entities. On a Schedule C, business owners take draws, pay tax on profits, and pay a 15% self-employment tax. If you’re part of a multi-member LLC, you pay self-employment tax on any guaranteed payments you’ve taken plus profits that flow through on a K-1.
The entities that are perhaps LLCs and taxed as an S corporation versus formed as an S corporation (they’re the same thing) take wages and get a K-1 at the end of the year with flow through ordinary income in box one for the ordinary income rate.
Remember, it’s all about strategy and structure. You need to consider these before you file your paperwork to form your business. Otherwise, you might find yourself paying more in taxes. You also want to make sure you’re in compliance every step of the way.
Finally, I encourage you, especially if you’re starting to make money, to engage with your accountant and not assume they’ll “babysit” you. After all, you’re an adult and need to take control of your business. It’s up to you to work with your accountant instead of complaining about those bills.