Starting up a new business is exciting. Its a time when owners naturally focus their attention on getting customers, growing revenue and building cash flow. But the IRS will take a big bite out of the income you generate if you don’t set up your business to reduce Uncle Sam’s tax bite.
You’ll want a solid plan right from the start to deal with Self Employment tax.
If you’re like most new business owners, you’ll take the path of least resistance when it comes to structuring your business from a tax perspective. That is, you operate as a Sole Proprietorship. That can be a big mistake. “Sole props” subject themselves to the full burden of Self-Employment Tax, which is 15 cents of tax on every $1.00 of net income that your business earns. That’s on top of Income Tax, which will add another 10, 15, even 25 cents of tax on every $1.00 of net income. Put together, these two taxes can add up to as much as 40% in taxes on your Form 1040 due next April 15th.
How do you reduce Uncle Sam’s tax bite? You do so by pro-actively structuring your business tax-wise.
Most startups don’t realize that you become a “sole proprietor” by default. It’s the legal entity structure given to you if don’t otherwise form a Limited Liability Company or incorporate when you launch your business.
Some new business owners immediately pull back at the idea of incorporating. “I’m not big enough to incorporate… I’m just starting out… I’m not that profitable”, and so on. That’s stinking thinking; it isn’t true, and it holds them back from properly setting up their business to reduce taxes right from the jump.
So lets de-mystify a couple of the more popular choices:
Limited Liabilty Company (LLC). In recent years, LLCs have become increasingly popular. They are easy to set up, and not expensive to maintain in terms of your time or your money. Legally, an LLC does just what it’s name implies: it legally shields your personal assets (your home, your IRA, your jewelry, etc) from the risks of operating a business in today’s lawsuit-happy society.
But LLC owners are technically ‘self-employed’ as defined by the IRS tax code, so this choice still leaves you exposed to Self-Employment Tax (which is basically just another term used to describe the Social Security and Medicare taxes you have to pay when you own your own business and have no one deducting these taxes from your compensation).
S Corporation. Created under Subchapter S of Chapter 1 of the Internal Revenue Code of the United States, S corporations are a separate legal person from the owner/employee. Unlike a regular C Corporation, an S corporation is a “pass-Through” entity. That is, the net income (or net loss) of the business is passed on to the individual owners via a Form K-1. The benefit to you is your personal exemptions and deductions can be used to reduce your tax liability arising from the S Corp income.
An S Corp can actually pay you in two ways; (1.) as an employee via a W-2, and (2.) as the owner via the K-1.
As I tell my tax clients, you wear two hats as the owner/employee of an S Corp.
- When you wear your employee hat, and do the work of the business, you are paid ‘reasonable compensation’, as would any other employee doing the same work. The corporation in this case is liable for payroll taxes –Social Security and Medicare included– on each dollar you are paid as a corporate employee.
- But you also wear a shareholder or owner hat, and any profit earned by the business over and above your employee wages is not subject to Self Employment tax. You’re subject to increased payroll tax, but subject to less tax on your Form 1040 income tax return. The trade off can save you thousands of dollars each year.
Actual tax savings will vary, and depend on your individual circumstances. Sit down with a small business accountant and/or an attorney to determine what legal structure is best suited to your situation, and will help you achieve your objectives, from both a legal and a tax perspective.
Anchor on This: Set up your business right–right from the start–with a proper legal entity structure designed to reduce Uncle Sam’s tax bite. You’ll save on your business taxes when you do. And a tax dollar saved is way more than a dollar earned!