When I was younger, I loved to read Choose Your Own Adventure books. They caught my attention because no matter which path you took, you’d find yourself on a new adventure. Starting a new business is the equivalent of living in a Choose Your Own Adventure book. What type of business to start? How much cash should I put into it? Should I take out a loan or use savings for it? What type of business entity structure should I use?
It’s the question of which entity structure that I have been asked probably more than any other throughout my career.
Traditionally CPAs have been a one-stop shop for anything related to numbers. However, at our firm, McNair & Associates, we’ve picked the one or two areas which we have a lot of experience in and focus there. One of these niche areas we focus on for our clients is the entrepreneurial world.
We work with clients who are starting a new business or may have an existing business they are looking to grow. We look for clients who want to maximize their cash flow, reduce their tax burden, and embrace an overall strategy that’s bigger than just a financial investment in their business. We have young start-up retail store clients with revenues under $400,000 per year, as well as large scale clients which are shooting for $100 million in sales this year.
The Top 2 Corporate Entity Tax Questions
From this broad range of clients, almost all of them have asked us if they have the proper entity structure in the last year alone. Their top questions are:
- Do I have to pay payroll taxes?
- What about double taxation?
When clients who have rolled their 401(k) into a C-corporation via a ROBS arrangement, their biggest questions are specifically about the tax benefits of a C-corp.
Do I Have to Pay Payroll Taxes?
If you’re an employee of an LLC which you own individually or in a partnership or a C-corp (or even an S-Corporation), you will have to pay payroll taxes on your salary as you were an employee of an entity you didn’t own. There’s no getting around that fact.
In general (without situational details), I would say that the payroll tax issue isn’t a major concern. As you must pay payroll taxes as an employee of your LLC and the profits at the end of the year have a Self-Employment tax, which is above and beyond regular payroll tax — you’re paying the same.?As a C-corporation, you’ll take a reasonable salary on a W-2, which you are required to do in an LLC, another form of partnership, or S-corporation anyway.
Corporations and Double Taxation
The bigger elephant in the room is the double taxation myth. It’s not even fair to call it a myth — it’s not like the Lochness Monster or Bigfoot.
Double taxation does exist, but the real question should be: Is double taxation really as big of a problem as it’s been thought of in the past?
Let’s do some comparisons.
If you have an LLC taxed as a partnership or even just a regular partnership, you will have self-employment tax at the end of the year on the income of the business — even if you do not personally take the money out. This is the IRS’ way of presuming you are keeping all of the income as earnings. The self-employment tax is 15.3 percent, which is made up of 12.4 percent for Social Security and 2.9 percent for Medicare (the limitations on some of this varies by year).
In addition to this tax, you would have an income tax. Depending on your total income, the tax bracket would likely be in the 10 percent to 37 percent range, not counting any state income tax. To be more specific, at the individual income level, if you have income under $38,700, your bracket will likely be 12 percent. Anything over that will put you at 22 percent tax or higher — up to 37 percent. A corporation, however, would pay a flat 21 percent tax on the income of the entity.
Double taxation applies when the corporation then distributes the left-over income to the shareholders as a dividend, and the shareholder pays tax on the money received.
Double taxation was a more frequent discussion when corporations would pay tax on their income and then distribute a dividend to their shareholders — then shareholders would pay tax on the dividend. It was widely unpopular when corporate tax rates were in the 30 percent to 50 percent or more rate, and individual income tax rates were over 40 percent.
Now that corporate and individual tax rates are at low levels, the negative stigma no longer exists. In 2018 for example, the dividend tax rate was between 15 percent to 20 percent, depending on your income bracket.
Note, if your ordinary income is:
- Less than $38,700, the qualified dividends have no tax.
- Between $38,600 and $425,800, the qualified dividend tax is at 15 percent.
- Higher than $425,800, the qualified dividend tax rate is at 20 percent.
Let’s be specific with an example. For the example’s sake, we’ll presume all else is equal — the same wages are taken by the employees in both entities. As with all tax law, there will always be some potential exceptions, but for this case, we’ll also presume the income listed is after any potential qualified business income deductions related to qualified businesses.
Let’s say you have an LLC taxed as a partnership which makes $100,000. The tax you could be expected to pay would be 15.3 percent self-employment tax plus individual income tax at roughly 22 percent to 24 percent.
LLC or other flow through entity partnership$100,000
Self-Employment tax * $(15,300) (15.3% self-employment tax)
* paid through the individual tax return
Original Income $100,000
Minus Self-Employment (15,300)
Minus Individual Tax (20,317)
After Tax Dollars $64,383
Note: The above example is applying the 22 percent tax directly to the additional taxable income under the presumption there are other income/deductions, to determine what that additional income could be taxed. In addition, the social security portion of self-employment tax could be limited based on other sources of income.
If you have a corporation with the same $100,000 of income, the tax rate would be 21 percent tax (corporate tax), that would leave the corporation with $79,000. Then, if the corporation instituted a dividend to its shareholders (i.e., you) of the full $79,000, the 15 percent dividend tax would be $11,850 (15% * $79,000), so the full after-tax amounts would be $67,150.
Corporation Taxable Income $100,000
Minus Corporate Tax (15,300) (21% corporate tax rate)
After tax income at Corp level $79,000
If Corp does full dividend to shareholders
Qualified Dividend $79,000
Dividend Tax (11,850) (15% qualified tax rate)
After-Tax Dollars Left Over = $67,150
Note: The above example does not factor into it any other income or deductions for the shareholder. There are an infinite number of variations to the above that would adjust these numbers, but the context is meant to give you an overview of the effects of different taxes.
As the income increases, so will the potential savings under the new tax rules. As seen from the tax brackets, the income tax rate at the individual level starts to creep up.
For individuals, the incremental rate goes to 32 percent at $157,501 and to 35 percent at income over $200,001 – all the while the corporate tax rate stays the same at 21 percent.
At $200,000 in income, the after-tax take home for the corporation structure would be approximately $134,300 ($200K * 21 percent, then 15 percent dividend tax on remainder for $134,300 of net take home). Whereas at the individual level you have likely increased your tax rate to 32 percent, so you would have net take home in the $119,000 range ($200K minus self-employment tax and minus tax at 32 percent), or a difference in take home of $15,300. This example also presumes you are applying the 32 percent tax directly to the additional taxable income under the presumption there is other income/deductions, so as to determine what the potential increase in tax would be from the income. In addition, a portion of the self-employment tax is only calculated up through $118,500.
Again, there are unlimited iterations and scenarios that would change the above numbers for your situation, inclusive of how much you took out as W-2 income, your other individual deductions or credits, your filing status, as well as any other tax planning strategies implemented that are not factored into the above calculations.
Jason Griffith, CPA, CMA
Partner of McNair & Associates, CPAs and Forensic Accountants
2018 Income Tax Brackets
|Rate||Individuals||Married Filing Jointly|
|10%||Up to $9,525||Up to $19,050|
|12%||$9,526 to $38,700||$19,051 to $77,400|
|22%||38,701 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$165,001 to $315,000|
|32%||$157,501 to $200,000||$315,001 to $400,000|
|35%||$200,001 to $500,000||$400,001 to $600,000|
|37%||over $500,000||over $600,000|
+ Self Employment Tax Rate: 15.3%
|Rate||Individuals||Married Filing Jointly|
|0%||Up to $38,600||Up to $77,200|
|15%||$38,601 to $425,800||$77,201 to $479,000|
|20%||$ 425,801 or more||$479,000 or more|
2018 Corporate Tax Rate: 21%
2018 Capital Gains Tax Brackets
Jason F. Griffith is one of the principals of McNair & Associates, a Las Vegas-based CPA firm specializing in working with entrepreneurs. He is the author of Identify, Acquire, Repeat: A Step-by-Step Guide to a Multi-Million Dollar Acquisition Strategy, 2017. Jason has served as the head of Strategy and Acquisitions for public and private companies, as well as having founding another CPA firm which grew to 6 offices with over 50 employees. His experiences in all of these projects give him a unique perspective, ideas, and ability to provide valuable input to the company.