My clients often ask me to help them choose the best entity for their business. Many just assume it should be an LLC, even when there is no good reason to have one. Others have been talking to relatives and friends who routinely recommend an S Corporation. Others don’t bother to ask me until they have already started an LLC or corporation. Here’s a brief overview.

What are the most common options?

• Sole Proprietor – just do business in your own name, or a DBA
• Partnership – assuming you have partners
• Limited Liability Company – LLC – with or without partners
• S Corporation
• C Corporation

I’ll outline the main considerations to keep in mind, then I will discuss each entity and its pros and cons.

MAIN CONSIDERATIONS

Separate entity

Partnerships, LLCs and corporations are separate entities that register with the state and file separate tax returns. As a sole proprietor, your business is not separated from your personal affairs – you file your business taxes as part of your personal tax return. The same goes for a single-member LLC, which is disregarded for federal tax purposes, although there may be a separate state tax or information return required.

Limited liability

As an individual or sole proprietor, you are liable for all of your debts and other liabilities, as are the partners in a general partnership. With a corporation or LLC, and some partnerships, though, your liability is generally limited to your investment in the business. There are exceptions, though, in the case of fraud or lack of separation of the business from your personal affairs. Remember that liability or E & O insurance can often serve the same function of reducing your liability.

Pass-through of income

Most of the entities discussed here result in business income being taxed on your personal tax return. Partnerships, LLCs and S corps are called “pass-through entities” because they don’t pay income tax. Rather, your share of the business income passes through to your personal tax return. Sole proprietor income is taxed directly on your personal return. C Corporations, however, do not pass through income, and they do pay tax.

Double taxation

Partnerships, LLCs and S Corps do not have double taxation, but it is an issue with C Corporations. The corporation pays tax, then it distributes its income to you, the shareholder, in the form of a dividend. You then pay tax on the dividend. This means that the same income of the corporation is taxed twice by the time you receive it. Generally speaking, the net tax rate is higher than if the income had passed through to you directly.

Deduction of expenses

You can deduct your business expenses in any of the entities discussed here. There is no real difference in this regard between sole proprietorship and the pass-through entities. Expenses may include automobile expenses, home office and health insurance. There may be an opportunity to deduct a few more expenses in a C Corp, such as medical expenses. S Corps are required to pay officers a reasonable salary, to ensure that payroll taxes are paid, while a C Corp can’t pay an excessive salary, because it would reduce double taxation.

This is a motivating reason to have your own business, as you can’t deduct any business expenses if you receive a W-2 salary from an employer. Classic examples of unfair results here include Uber drivers, who won’t be able to deduct gas or other costs of operating their vehicles if they are subject to California’s new law requiring that they be treated as employees.

Payroll tax / self-employment tax

The main payroll taxes are Social Security tax and Medicare tax. If you have received a W-2 from an employer, you will see that they deduct 6.2% for Social Security and 1.45% for Medicare from your paycheck. What they don’t tell you is that the employer also pays the same amount. When you have a business, you are responsible for paying the employer’s share as well as the employee’s share, for a total of 15.3%. A sole proprietor or single-member LLC pays this directly on the personal return in the form of “self-employment tax”, and you also would pay self-employment tax on relevant partnership or LLC pass-through income. With an S Corp, you pay payroll tax on the W-2 salary that you pay yourself, but not on the corporation’s pass-through income.

Retirement contributions

One of the big advantages of having your own business is that you can make much larger contributions to retirement plans, depending on your income. SEP IRAs and 401(k)s are the most common plans that can result in deductible contributions of up to $57,000 in 2020. For corporations, contributions are limited to a percentage of W-2 salary paid, and the other entities are limited to approximately 20% of their income. Partnerships and multi-member LLCs must establish the retirement plans, as partners can’t set up individual plans. Sole proprietors can set up plans for themselves.

Operating costs

There are no particular costs directly related to being a sole proprietor. Corporations, partnerships and multi-member LLCs must file federal tax returns, and those returns are generally more expensive to prepare. Some states have reporting requirements and/or minimum taxes. California, for example, has a minimum tax of $800 on corporations, LLCs and some partnerships. S Corps are required to pay officers a salary, so there will also be payroll processing fees.

Type of business

Some businesses have special considerations. For example, I don’t think you would want to use an S Corp for a rental real estate business, because you would be required to pay yourself a salary and pay payroll taxes on what is really investment income. If you operate a day care business, or some other business with high potential for liability, I would suggest an entity that potentially limits that liability.

THE PROS AND CONS

Sole Proprietor

Generally, there are really no negative aspects to being a sole proprietor. You keep your business records separate from your personal finances, report your income and pay self-employment taxes. You can deduct all of your business expenses and make substantial retirement contributions. You can have employees and operate just as you would with an LLC or corporation. You don’t have additional state taxes or tax preparation fees, but you don’t have limited liability. Most businesses can make up for the lack of limited liability by purchasing insurance.

Partnership

If you do business with one or more partners, you are in a partnership. That will require a separate tax return, and if it is a limited partnership, there may be state filing requirements and minimum taxes. Married couples who operate a business together may elect not to be treated as a partnership. All expense deduction rules apply, including retirement contributions, and net income is divided between the partners and your share is reported on your personal return. You will pay self-employment tax on your business income, unless you are a limited partner, and there is generally no limited liability, unless you are a passive limited partner.

LLC – Limited Liability Company

You can elect to have an LLC taxed as an S Corporation. Otherwise, it is treated as a partnership. A single member LLC (owners are referred to as members in an LLC) is treated differently from an LLC with multiple members.

LLC- Single Member

Let me start by saying I generally don’t recommend forming an LLC if you are the only member. It is called a “disregarded entity” for federal purposes, so you file taxes exactly the same way you would if you were a sole proprietor. Limited liability may be beneficial, but it can be easily thwarted by a creditor if they can show that the LLC is not substantially separated from your personal finances, and there’s no chance anyone is going to lend you money or lease you a car without a personal guarantee. And for your trouble, you get to pay California a minimum tax of $800, although it is lower in most states.

LLC – Multiple Members

A multiple member LLC taxed as a partnership is, well… taxed as a partnership. See above.

S Corporation

An S Corporation can be a corporation or an LLC registered with the state. Either way you must file an election to be taxed as an S Corp. Like a partnership, revenues and expenses are reported, but the corporation does not pay tax. Net income passes through to your personal tax return (your share of the income if there are other shareholders) so the income is only taxed once.

The most important feature of an S Corp is that the corporation is required to pay its officers a “reasonable salary.” This is not defined, but a guide would be the salary you would have to pay someone to do your job. The purpose of this rule is to be sure that you are paying reasonable payroll taxes – Social Security and Medicare.

The profit passed through to your personal tax return is not subject to self-employment tax (as it is for a partnership), so if you pay a relatively low salary, and pass more income through, then you pay less tax overall. This is often used as a selling point on choosing to use an S Corp, but remember that Social Security and Medicare taxes are good taxes (if there is such a thing) because they are credited to your account for future benefits when you get older. Do you really want to cheat yourself on this valuable future benefit?

Your retirement contributions are limited to 25% of the W-2 salary you pay yourself, so this is another incentive to pay a larger salary.

There are restrictions on who can be a shareholder in an S Corporation. You must be a US citizen or resident, an individual and there can’t be more than 100 shareholders.

C Corporation

Most small businesses do not choose the C Corp as the ideal entity, because of the double taxation discussed above. The corporation pays tax, then the earnings are taxed again when they are paid to you as dividends. Before you jump on the obvious the loopholes, though, you can’t take an excessive salary deduction to transfer the tax to your personal return, and you can’t accumulate earnings without paying a dividend unless there is a good reason.

So next time a client asks me which entity is best for their business, I’ll be referring them to this article. Then we can have an informed conversation.

I first came upon this issue some years ago, when I produced an independent motion picture (Pterodactyl Woman From Beverly Hills – look it up). I had no experience with filmmaking, and had never run a business before, so we paid everyone – actors, artists, drivers, electricians, etc. – with 1099s, treating them as independent contractors. It seemed like a good idea, because there was minimal paperwork, and we didn’t pay the workers’ payroll taxes out of our limited budget… But the California Employment Development Department (EDD) disagreed. It turns out there are very specific rules defining who is an independent contractor and who is an employee. It was an expensive lesson.

What’s at Issue

When an employer treats a worker as an employee, the employer is required to pay 7.65% Social Security and Medicare taxes (in addition to the same amount that is deducted from the employee’s pay) as well as unemployment and other state payroll taxes. This not required for independent contractors, so there is a considerable cost difference.

When a worker is treated as an independent contractor, they are considered to be running their own business. This means they have to pay 15.3% for Social Security and Medicare taxes (both the employee’s and the employer’s portion) over and above their income tax. They do not pay unemployment tax, and can’t draw unemployment, because they are considered to be self-employed, and they probably pay more for their tax return, because it is now a more complex return.

What Are the Rules?

There is a lot of literature on the subject, and there has been a fair amount of room for interpretation, but California recently made it much more difficult to treat workers as independent contractors. Let’s look at the test that came out of a California Supreme Court ruling from 2018.

1.  Is the worker free from the control and direction of the employer in connection with performance of the work a) under the contract, and b) in fact?
2. Is the worker doing work that falls outside the usual business of the employer?
3. Does the worker ordinarily do independent work of the same nature as the work they are doing for the employer?
4. Is the worker actually in business for themselves?

The second question is the killer for many employers. I can be an independent contractor because I do taxes, which is not my clients’ business. But are you designing or selling the company’s product, providing the company’s services, shipping its products? Then you are an employee.

Here are some more thoughts:

• Are you paid by the hour or by the job?
• Can you quit and walk away, or are you obligated to complete the job?
• How long is the engagement?
• Are particular skills required for the job?
• Who provides the equipment used on the job?
• Are you a shareholder or have a financial interest in the employer?
• Do both parties actually believe it is a contract engagement, and not a regular job?

Penalties for Employers

There are federal and state penalties for misclassifying employees as independent contractors.

The IRS may require the employer to pay not only the employer’s portion of Social Security and Medicare taxes, but also the employee’s portion. There can also be a penalty of $5,000 per misclassified employee, and 1.5% of the employee’s income tax on the wages, as well as an additional 20% of payroll taxes that were not withheld.

There are state penalties as well. California, for example, requires the employer to pay unpaid income tax, unemployment insurance and disability insurance. Plus interest, of course. Penalties can range from $5,000 to $25,000 depending on whether the employer has a pattern of misclassifying employees.

What Can the Employee Do?

In my situation with the film production, one of the actors filed an unemployment claim, and the EDD noticed we had never filed payroll taxes. Even if this hadn’t happened, one or more of the workers could have reported the situation.

A misclassified employee can file IRS form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding”.  Google it. This will result in the IRS making an evaluation, and if the worker is determined to be a misclassified employee, the employer will be required to pay at least the employer portion of payroll taxes. The worker can also file a wage claim with the state.

In my experience, my clients who are misclassified employees are reluctant to report the employer for the violation. They are concerned about losing their jobs, of course, and reporting violations is a sure-fire way to piss off your boss. It’s a whole different situation after they leave the job, though. Meanwhile, we can only hope for more active enforcement by the IRS and the state.

In my experience, a lot of people don’t pay enough attention to their Subchapter S Corporations until tax time, when it’s sometimes too late to correct errors or oversights.

You formed the S Corp because of the benefits you would get from it, so it would be a shame to operate it in such a sloppy way that you could miss out on some of those benefits. Please take a moment to be sure you are following these guidelines, and make any necessary changes before the end of the year.

Reasons for forming an S Corp generally include:

• Reducing payroll taxes on a portion of your income
• Retirement contributions in excess of the limits on IRAs and 401(k) plans
• Deduction of health insurance costs
• Limited liability

I will discuss these items briefly below, then move on to some other relevant thoughts.

W-2s and Payroll Taxes

Generally speaking, your S Corp does not pay tax, but rather the income “passes through” to your personal tax return. This pass-through income is taxed at your regular rates, but it is not subject to the federal and state payroll taxes you would pay if you were an employee.

It is important to note that a shareholder of an S Corp is not self-employed, but is actually an employee of the company. As such, you are required to pay yourself a reasonable salary, a term that is not clearly defined, but is intended to prevent shareholders from entirely avoiding Social Security, Medicare and other payroll taxes. One way to look at it is that you should pay yourself what it would cost to hire someone to do your job.

Your salary is treated as a deduction by the company, so you aren’t taxed twice. You pay payroll taxes on your salary, but you don’t pay payroll taxes on the remainder of the S Corp’s income after deducting your salary. That’s one of the benefits of an S Corp.

Action required:  Pay yourself a salary, and issue a W-2 at the end of the year. I suggest you use a payroll service to be sure you are in full compliance with the complex rules and regulations surrounding payroll. Do this before the end of the year.

Retirement Contributions

As an S Corp owner, you have a choice of retirement plans that you can establish. One of the most popular plans is a Simplified Employee Pension, or SEP. An advantage of a SEP plan is that the company can contribute a percentage of your salary, up to a maximum contribution of $54,000. This is substantially higher than the limits for IRAs and 401(k) plans. Do be aware, though, that you also have to offer the plan to your other eligible employees, and contribute the same percentage on their behalf. This is a specialized and complex area, so you should speak with a knowledgeable professional on the subject.

It is important to note again that as an S Corp shareholder, you are not self-employed, but rather an employee of the company. The retirement plan must be created in the name of the company, not yourself, and the contributions are made by the company. Contributions are deductible from the company’s income of course.

Action required: You can establish a SEP retirement plan any time during the year, or up to the date when the company’s tax return is due (even if you file for an extension). Other types of retirement plans may have different rules, so be sure to investigate before the end of the year.

Health Insurance

As an S Corp shareholder, you can deduct health insurance costs for yourself and your family directly on your tax return. But there is a special process for doing so, and it is important that you follow it. The company must pay for your health insurance. It is acceptable to have the insurance in your own name and make the payments yourself, but you need to have the company reimburse you, and deduct the expense.

Health insurance paid by the company is considered compensation to you, and must be added to your salary on your W-2 at the end of the year. You will not pay payroll tax on this amount, but it must be included in gross earnings. You then deduct the amount directly on your personal tax return.

It seems a bit convoluted, but those are the rules.

Action required:  Be sure to have the company reimburse you for medical insurance payments before the end of the year, and be sure to instruct your payroll service to include it on your W-2. If the payroll service gives you trouble, ask to speak to a supervisor… they do this for thousands of people every year.

Limited Liability

To ensure that your S Corp offers limited liability you need to be disciplined in the way you operate it. Without going into depth, you need to establish that it is a separate entity, and not just an extension of your own personal finances. That includes keeping a separate bank account and credit cards, maintaining careful accounting records and keeping up to date with your state’s filing requirements.

Action required: Check that you are following the appropriate discipline to ensure your company is a separate entity.

Estimated Tax Payments

We are required to make payments during the year of the amount of tax we estimate owing for the whole year. This is easy for the salary you pay yourself, because you are expected to withhold and pay federal and state tax from each paycheck.

The issue here is the tax you expect to pay on the company’s earnings that pass through to your personal return. Depending on your situation, these amounts can be substantial, and to add insult to injury, there are penalties for underpayment of estimated tax.

Action required:  Speak with your tax professional at least once during the year, to be sure you are making appropriate estimated tax payments.

State and Local Tax Registration

Many cities have tax filing requirements, and it can be annoying and expensive if you haven’t met their requirements. Los Angeles, for example, assesses tax on income above a specified level, but also has a requirement to register for a business license and renew it every year.

If you are operating outside the state in which you registered the company, you need to check on filing requirements. California, for example, is very aggressive about finding and taxing out-of-state businesses that do business there.

Action required: Learn the filing requirements, and follow them. They will find you if you don’t.

Auto Expense and Home Office

The S Corp can own a car, and deduct any allowable business expenses, but you may find it easier to keep the car in your own name, and submit for reimbursement any business mileage, documenting the locations, distances and business purpose of each trip. You would complete form 2106 on your personal return, and deduct the reimbursement. I often find it convenient and preferable to use the IRS standard mileage rate where eligible – it’s 53.5 cents per mile in 2017.

Similarly, assuming you meet the rigorous and very specific requirements, you can deduct an expense for the business use of your home office. Again, submit expense reports for reimbursement, detailing the square footage of your office space and the total size of your home, in addition to specific allocated costs such as rent, mortgage, utilities, etc.

Action required: Submit detailed expense reports, and have the company reimburse you. Do this before the end of the year.

An S Corporation can be a very useful business format, but there are rules that need to be followed to ensure you get all the appropriate benefits. And remember that an S Corp is not necessarily the best entity for you, depending on your situation and your objectives.

As always, speak to a tax professional before acting… and after!

A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

–  The interest portion of your mortgage payment and your property taxes are tax deductible
–  If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
–  If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
–  If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
–  If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
–  If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
–  If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.

Whenever a client tells me they’ve formed, or plan to form an LLC, I ask…

Why?

Especially if they don’t have partners in their business.

The question takes a lot of people by surprise, because they just assume they need a company to start a business, or they think it’s the only way to achieve liability protection. They often haven’t considered the costs of forming and maintaining an LLC, and even more often don’t know how to operate it prudently.

An LLC (Limited Liability Company) can be a useful structure under certain circumstances, but they aren’t for everyone. Here are some thoughts:

– LLCs are kind of cool. I had an LLC myself, and it felt pretty cool, until I added up all the other factors and costs

– You don’t need an LLC to operate a business

– Limited liability may give you some protection against creditors or liability claims, but it’s not a sure thing

– A single-member LLC doesn’t even exist for federal tax purposes, so it’s exactly the same as operating as a sole proprietor

– Maybe an S Corp would serve your needs better

– There may be a state tax or filing fees for your LLC – the California minimum tax is $800

– You need to stay current with all LLC filing requirements for your state, or you may lose the benefits of the LLC

– Forming an LLC in another state may not save you tax in your home state

– Tax rates are higher on self-employment earnings – with or without an LLC – so you need to make estimated tax payments

– You can make much larger deductible retirement contributions if you are self-employed – with or without an LLC

– You can deduct your health insurance if you’re self-employed – with or without an LLC

Sole Proprietorship

There is nothing to stop you from starting a business without an LLC. When you operate a business in your own name or a DBA, it’s called a Sole Proprietorship. You can buy and sell products or services, buy equipment, rent space and incur operating expenses for your business. If you keep careful records and maintain separate bank accounts, the business can be accounted for separately from your personal activities.

For tax purposes, your business is reported on Schedule C of your personal tax return – Profit or Loss from Business. Your net income is taxed as ordinary income, and is subject to an additional Self-Employment Tax. This is basically your social security and medicare tax that you would pay if you received a paycheck from an employer. The difference is that you pay the employer share of these taxes, too. The calculation is complicated, but it comes to a little under 15%. You need to keep this in mind when making estimated tax payments during the year.

In a sole proprietorship, there is no built-in protection against creditors or liability claims.

Single Member LLC

If you are the only member of your LLC, you are taxed exactly the same as if you were a sole proprietor. A single member LLC is called a Disregarded Entity for tax purposes, which means that the IRS doesn’t even recognize its existence. Your business income is reported on Schedule C of your personal tax return, and you pay the Self-Employment Tax.

The only difference is that, depending on which state you are in, you may have to file a separate LLC tax return or information return, and/or pay an LLC tax or filing fee.

And oh, yeah… there is theoretically some protection against creditors and liability claims.

Limited Liability

Yes, limited liability means that the company is a separate entity for legal purposes, and creditors or legal claimants can only go after the company’s assets. You are only liable to lose any amounts you have invested or lent to the company, and your home and other personal assets are protected. That’s the theory, anyway.

Let’s look at it practically… Is anybody really going to lend money, lease property or give credit to your single member LLC without a personal guarantee from you? I didn’t think so. So what is the benefit of limited liability against creditors if all the LLC debts are your personal responsibility?

And what about liability claims? Sure, you have limited liability, as long as you operate the LLC in a disciplined fashion… and if you aren’t crooked. If a claimant or creditor is determined to go after your personal assets, they may try to “pierce the corporate veil.” That is, if they can demonstrate that you didn’t use separate bank accounts or separate credit cards, and generally didn’t operate the business as an entity completely separate from your personal affairs, they may get past the limited liability protection offered by the LLC. The same goes if they can demonstrate that you behaved fraudulently.

Insurance

How much liability do you expect to have? Most businesses don’t have that much to worry about – how much liability can your IT consulting business or online retail operation really generate? Liability insurance should cover most situations at a reasonable cost, and umbrella insurance would be an added layer of protection. A lot easier than operating and paying for an LLC.

Of course, there are businesses with potentially greater liability. It is common to see LLCs formed for day care facilities and rental properties. This is typically in addition to liability insurance. Just remember to be disciplined in keeping the business separate, and keep up to date on your state filings and payments.

Subchapter S Corporation (S Corp)

Depending on the size of your business, you might be better off forming an S Corp. One of the features of an S Corp is that not all of your income is subject to Self-Employment Tax, as it is in an LLC. There are a lot of issues that need to be weighed in going this route, but there are even more rules that need to be followed to the letter in order to realize the ongoing benefits. I’ve seen many S Corps formed by people who were never taught how to operate them, and left them exposed to unfavorable tax and legal consequences.

Out-of-State LLCs

Some states have high taxes and fees for LLCs. California, for example, has a minimum tax of $800. This gives some people the bright idea of forming their LLC in a state with lower costs. Don’t do it. Your home state – especially California – will catch you, and they will claim that you are conducting business in that state. You will then be required to pay tax and penalties.

Delaware is a very popular state in which to form an LLC, for a variety of reasons. Depending on your home state, you will probably want to register the LLC as a foreign LLC doing business in your state. That is certainly the case in California.

Retirement Plans

You can deduct much larger retirement contributions if you are self-employed. While a regular IRA contribution is limited to $5,500, a SEP IRA contribution can be 20% of your self-employment income, up to a total contribution of $54,000. You don’t need to have an LLC to be eligible for a SEP IRA. The same goes for deducting your health insurance.

Am I saying you probably don’t need a single member LLC? I like to joke that the average life of an LLC among my clients is a year and a half. They don’t mind paying the $800 California tax the first time, because they are full of hope and ambition, but the second time it comes up, it’s pretty hard to see what they are getting for their money… So yeah, I’m saying you probably don’t need an LLC.

Who May Benefit

This article may benefit you if:

1. Your income is over $157,500 ($315,000 if married filing jointly),and
2. You are:

• Self-employed, or
• A partner in a partnership or a member of an LLC that is taxed as a partnership

Suggestion: You may spare yourself some reading by jumping to the two examples I provided below.

Overview

The tax changes in 2018 include some provisions that are very favorable to businesses. One important change was to drop the tax rate for C corporations to a flat 21%. This is a significant reduction, but doesn’t apply to businesses that operate as partnerships, LLCs, S corporations or sole proprietorships.

To provide a similar benefit to these businesses, the IRS introduced Section 199A Qualified Business Income deduction. This allows individuals with income from businesses that operate as partnerships, LLCs, S corporations or sole proprietorships to take a tax deduction of 20% of their share of Qualified Business Income (QBI)… But there are rules, definitions and restrictions:

The rules and restrictions include a phase-out of the deduction, when your income exceeds certain thresholds. BUT these restrictions are reduced or eliminated if your business has W-2 payroll expenses or substantial investment in qualified assets.

S Corps are required to pay a reasonable W-2 salary to their owners, but partnerships, LLCs and sole proprietors cannot. That’s why you may want to form an S Corp.

Why is the QBI Deduction Important?

You can take a tax deduction of up to 20% of the net income generated by your business. It can be a very big deal.

What is QBI?

Qualified Business Income is the income from your trade or business.

There are no restrictions on the types of businesses income that qualify for the QBI deduction, as long as the idividual claiming the deduction has taxable income under $157,500 (or $314,000 if married filing jointly). For those with higher taxable income, you will not be able to claim the deduction if you are in a Specified Service Business, as described below.

QBI is not intended to include income from personal services, so it specifically excludes employment income, as well as income from Specified Services Businesses – in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletic, financial and brokerage services. Engineers and architects, however, are eligible for the QBI deduction. Speak to your tax professional for a more thorough and complete discussion of your eligibility.

Owners of rental properties may also qualify for the QBI deduction, but the value of the properties will help you qualify if your income is above the phase-out thresholds, so the benefit of an S Corp would probably be irrelevant. And would also bring up other complex issues.

Payroll Expenses Can Save the Day

The QBI deduction phases out to nothing if your income exceeds $207,500 (or $415,000 if married filing jointly)… UNLESS your business had W-2 payroll expenses or substantial qualified assets. Let’s focus on the payroll:

If you are above the taxable income threshold, and if your income is not from a Specified Services Business, you can still claim the QBI deduction in an amount up to 50% of the W-2 payroll of the business.

Partnerships and other businesses may have employees, and their wages would count in this calculation, but many businesses don’t pay any W-2 wages at all, so they would lose the QBI deduction. Certainly, sole proprietors and partners in partnerships can’t pay themselves salaries… BUT S Corps can.

Example 1 – Sole Proprietor

A real estate broker operating as a sole proprietor earns $275,000 from his business activities, and reports his income on Schedule C of his tax return. He is not married, so he will pay tax on the entire $275,000. His income is over the threshold, so there is no QBI deduction.

If the same real estate broker operated his business as an S Corp, he would be required to pay himself a reasonable salary – say $125,000. Ignoring a few other details, his Qualified Business Income would be $150,000 ($275,000 income, less $125,000 W-2 salary paid to him by the company). His QBI deduction would be the lesser of (a) 20% of his QBI – $30,000, and (b) 50% of the W-2 wages – $62,500.

In this case, the real estate broker gets a tax deduction of $30,000 by forming an S Corp.

Example 2 – Partnership (or LLC taxed as a partnership)

The partnership earned $400,000. Partner A owns 50%, and received guaranteed payments for his services of $125,000. His income of $325,000 ($125,000 guaranteed payment, plus $200,000 share of partnership income) is fully taxed at ordinary tax rates. He is single, so his income is too high to qualify for the QBI deduction.

If the partnership filed an election to be treated as an S Corp, his guaranteed payment of $125,000 would be paid as W-2 wages, and his QBI would be $200,000. Assuming his business partner also received the same salary, and again ignoring a few details, his QBI deduction would be the lesser of (a) 20% of his QBI – $40,000, and (b) 50% of his share of W-2 wages – $67,500.

In this case, the partner gets a tax deduction of $40,000 by electing to have the partnership taxed as an S Corp.

NOTE: Even though the deadline for S Corp election has passed, the partnership can apply for late filing relief, and there is a good possibility that the S Corp election can be made effective for 2018.

Conclusion

This is not intended to be a thorough analysis of Section 199A of the tax code. Nor is it a full discussion of the pros and cons of an S Corp. Rather, it is an attempt to find good tax planning solutions. There are a lot of variables in the choosing the most appropriate business entity, and every situation is different. I would be happy to discuss your situation, and help you arrive at the most advantageous result.