What type of business structure should you use to limit your taxes and liability?
In this episode, Zacc Call and Laura Hadley discuss various business structures and their implications for your taxes and liability. They explain that most business structures are pass-through entities, except for C corporations which are subject to double taxation.
Plus they delve into sole proprietorships, partnerships, and limited liability corporations (LLCs), highlighting the risks and benefits of each.
Listen to gain insight on:
[00:00:00] Welcome to The Financial Call. We are financial advisors on a mission to guide you through the financial planning everyone should have. Whether you're doing it yourself or working with a financial advisor, these episodes will help you break down complicated financial topics into practical, actionable steps.Our mission is to guide motivated people to become financially successful. Welcome to The Financial Call. This is Business Owners, Season 6. First episode is Business Structures. And I mean, we'll talk about this in terms of it helping retirees, but this question I get most often from someone who's starting a business and they're trying to figure out what business type they should own.However, we will have a conversation later about exiting your business. That is episode four within season six. And during that episode, we'll talk about some of the tax ramifications of owning different business types and how that affects the tax upon exiting your business because it's very
[00:01:00] different, you know, some of these that have the best benefits along the way.Yeah. So we'll talk a little bit about that. But the main thing is we're going to talk about the different business structures that we see, why people pick different business structures, pros and cons, try to give some examples. And I think that's it. Anything else to add, Laura? I think we dive in. Okay, so every single time someone is trying to start a business, they hear a lot about, okay, is it an LLC?Is it an S corp? Is it an LLC taxed as an S corp? Is it a partnership? Is, or what about C corps? And those are entirely different. We're going to help you like put this together. And I actually wish you could see it. I'm going to help you understand that most of these are what they call pass through entities.The tax effects are passed through to you on your personal tax return. The only one that we'll talk about today that is not a pass through is a C
[00:02:00] corporation. When you hear politicians talking about corporate tax rates. They are specifically talking about C Corps. And when you hear people talk about double taxation, they are specifically talking about C Corps.Because the rest of the entities are not double taxed, because it just passes right through those entities. and hits your tax return and you pay it on your own tax return. But a C Corp has its own tax schedule, has to pay corporate tax. And then as you distribute that money out, then you personally have to pay taxes on it as well.So we'll explain a little bit more about that. But the one key distinction to first understand is most of all of the options that you've heard of. are pass through entities, and then C Corps are not. And big, big businesses are C Corps. However, I have a couple of clients that use C Corps in small businesses as well.So it's Oh, really? Yeah. C Corps are nice because you can raise money easier. And I think
[00:03:00] corporate transactions are easier. There are fewer restrictions as to what types of things can own a C Corp. Different trusts or entities. And so that flexibility comes at a little bit of a cost, right? You have to pay taxes twice.Yeah, exactly. That's a common theme if you haven't already picked it up from the Guided Paths series. That is, on one hand of this scale you have flexibility and on the other hand you have Taxes. And as you try to reduce taxes, you may also impact negatively your flexibility and control for the freedom and the flexibility.For sure. This is kind of funny. The C Corp, when I was learning these, trying to figure out, you know, what's what the C Corp is the biggest. So I always think of the C, the great big C. So if you're wondering the S Corp, C Corp, the C is big. So that's your big companies, the C Corps. Alright, so the pass through entities.So let's just start with the most basic. A sole proprietorship. And this really isn't an entity at all. All it is, is you doing business and you have a name that you do
[00:04:00] business under and you just file all of the information about that business. on your personal tax return. So, the sales from the business come in and you just write them in one of the schedules.This is Schedule C if it matters to you, but on your Schedule C you list in all of your sales, you list in the expenses, and you list in like deductible expenses and different things just within that Schedule C. And then at the bottom, there's going to be a net income from the business that then flows over to your 1040 and that's what you have to pay taxes on.So the business doesn't have its own tax rate, it just flows over to your 1040 and your own tax rate will apply here. As part of that, you have to pay FICA taxes, and that is probably a big piece to this conversation is FICA tax. So FICA tax is Social Security and Medicare taxes. Social Security and Medicare tax, if you are an employed individual, then you're paying
[00:05:00] 6.2% Social Security and 1. 45% Medicare. If you're employed by someone else, the business is also matching that they are required to pay 6. 2 and 1. 45 as well. So all in, this is around 15% taxes that are being paid on your behalf. In addition to any income tax you have. Exactly. So that doesn't even count the normal state and federal taxes.That's just taxes to cover Medicare and Social Security. And so it's a big number. And. What happens when you do a sole proprietorship is that all of that income flows through and you have to pay both the employee and the employer side. So it's super painful when you go from working for someone else to working for yourself because it adds another 7.65, right? Okay. So anyway, that's painful. Here's the risk of a sole proprietorship. All of your personal assets are at risk if someone sued your business activity. So let's say you have some sort of
[00:06:00] business that you do something and you injure someone or maybe someone injures themself at your place of business or something like that.Or someone feels that they have been mistreated and you haven't held up your end of a contract or something like that and they sue you and they win. They have the ability to go after your home, your personal assets and anything else on the table there. with a sole proprietorship. So it's simple because you just list out the items on your tax return, but it's risky in the sense that it exposes your entire personal net worth to risk of litigation and things like that.So you can create. Partnerships and limited partnerships, which may limit that liability. And a partnership is an entity that files its own return. Now it's still a pass through entity. You file your own return. And then let's say that Laura, you and I have a business, you own 60% of it. I own
[00:07:00] 40% of it and it makes a hundred dollars because we're just that good.We are great podcasters. We wish we could say the podcast made money. Folks, we're paying to talk to you. That's what's going on here. I'll take the 60%. That's great. Okay. So Laura gets 60 and I get 40. Whether we take that hundred dollars out of the business or not, the fact that we had earnings, meaning our income was, let's say our income was a thousand dollars and we had nine hundred dollars of expenses, we were left with a hundred dollars.Even if we chose to leave that hundred dollars in the partnership bank account, the taxation of it flows through. So, the form that the partnership would create is called a K 1. So Lara and I each get a K 1, her K 1 says she has to pay taxes on 60, my K 1 says I have to pay taxes on 40. And that goes on to our schedule.E as an echo, and then that goes through to our tax returns and we both pay our taxes on it. Okay. So that's
[00:08:00] how it comes through. Now that because it's a self employment situation, that partnership is something Laura and I are running as part of our jobs. Now, we have to pay FICA tax on that as well. So we're going to pay our regular income rates plus FICA tax.Okay. So there's something called a limited liability corporation. That's LLC. That is one of the most common structures these days, an LLC. Also files its own tax return. Also passes through on a K 1. The income and in an LLC, you have a little bit more flexibility around like limiting liability and things like that in a partnership.Most of the time you have a general partner and you also have limited partners and the limited partners may have limited liability, but the general partner does not. And so an LLC can improve that a little bit. I find that they're a little bit easier to work with. So an LLC is always
[00:09:00] taxed as either a partnership or as an S corporation.People don't really think about it this way, because the default is to be taxed as a partnership. So, when they set up their LLC, it's taxed just like a partnership. It flows through, all of the profits come through on a K 1. Lara pays taxes on her 60, I pay taxes on my 40. And we show it on our personal tax returns.We pay FICA tax on the whole thing. And we also have limited liability with LLCs. I like to think of it like a farm and you put little fences around different sections of animals. So let's say that I wanted to keep. And not literally running a farm as a business, but I want you to think of this as an analogy.Like, I want to protect some cattle that I have. And I'd like to also protect some chickens that I have over here. So I'm going to put separate fences around them. If a wolf gets into one of those two penned off areas, they're only going to have access to the
[00:10:00] assets within that fenced off area. So, if they get in with the cattle...Chickens are safe if they get in with the chickens, cattle is safe. So that helps you think about when it may make sense to set up multiple LLCs to put fences around particular assets to limit the ability of anybody to go after different assets that you may have. It also keeps the books really clean.Now, let's say you have two different businesses involved in completely different things. Like for example, I coach soccer and up until this point I haven't been paid for it, but I switched to a new club with one of my teams. So I'm actually going to get paid for this, which is kind of weird. And so I needed to set up a separate LLC for that, whereas I have my LLC that handles my Capita partnership.Now, if I had put that all in one LLC. And a kid gets hurt at a soccer game and comes after me. That's the kind of fence that we're talking about to put protection around different assets. And then just from a bookkeeping standpoint,
[00:11:00] it's cleaner to me to be able to say like, Oh, I had to buy this soccer equipment.Well, buying goals and balls and pennies and things like that doesn't really make sense for our financial advisor firm, but it does make sense for the soccer team. So then I can more easily explain why. Certain expenses are actually deductible within a tax return for the LLC. Or if eventually you're going to sell the business, you want your books clean for the buyer, and if someone's buying a finance firm and see a bunch of penny expenses or you know soccer balls, then that's going to get confusing. So that's something to think about as well down the road. You want to keep everything clean? Yep. Absolutely. Okay. So the next step is, An S corporation. Now, you can set up and have an S corporation that is not an LLC taxed as an S corporation, but I've not run into that. I mean, I've heard of it. I may have seen it once in my career. Most of the time if someone says they have an S corporation, What they really mean is I have an
[00:12:00] LLC taxed as an S Corp. You got it. And I've made an election to tax as an S Corp or to be treated as an S Corp. Now, why would someone do this? Why would someone pick to be an S Corp? What's going on here is the FICA tax. They're trying to control FICA tax. So far, all of the entities we've talked about are passed through entities and all of that K 1 income. goes through to their personal tax return, and then they have to pay FICA tax on all of it. And the self employment. So they're paying the 7. 65 for themself as the employee, and then the 7. 65 for the employer. So about a 15% tax rate is what you're paying on your income from your partnership. But with the LLC taxed as an S corp, you can separate out. What you pay the FICA tax on and what you have to pay taxes on. You just take it as a draw, correct? You got it. So think about it as income because you're an employee and income because you own something.
[00:13:00] Now, you shouldn't necessarily pay FICA tax on something that you get as an owner. I mean, think about like. Let's say the rental property, they're not going to have you pay that self employment tax on it, right? It's just because you own an asset that pays you income doesn't mean it's self employment income. So you should be able to structure that without having to pay FICA tax on it. But on an LLC tax, there's an S corp. You have to do what's called a reasonable wage. So you have to find some number and accountant may help you with this where you determine, okay, it's 000. I mean, it depends on your actual employment is the reasonable amount on which you should pay like a wage to yourself on which you should pay FICA tax. So you can't pay yourself 20, 000 a year and only pay. Mike attacks on the 20, 000. Yeah. I mean, that's a reasonable. Yes, exactly. It's worth that amount, but something to keep in mind. But if you're able, so let's say, let's give an example, Zacc. So say your business, you're earning a hundred thousand. Maybe it's not the
[00:14:00] value of your job. Isn't worth a hundred thousand. It's reasonable to pay someone 60, 000 to do that job. So you're taking 60, 000. As is it come out as a W 2? Yes, so that's exactly right. So when the LLC files its own tax return, it doesn't pay taxes, right? Because it's a pass through entity. But it does still do a tax return. So it calculates out the expenses of the business. And you might not even be the only employee, right? It's going to go through and look at all the employees and all of the wages paid are an expense. So even your own wage. It's an expense to the business. So your wage decreases the K 1 pass through income as an owner and it shows up as W 2 income for whoever is doing that work. So in your example, Laura, you, you pay yourself 60, 000 and it shows up as a W 2. We're paying the FICA tax on that. That's counting towards our social security earnings, we got that and then whatever's left over after expenses are calculated You can take
[00:15:00] that as a draw through a k1 and that's not taxable to you. You're not paying the FICA tax on it So let's say after all that we have 20, 000 left over because I have another employee that I paid 20, 000 Yeah, I got 60, 000 as a w 2 paying FICA tax paid my employee 20, 000 there's 20, 000 left over I take that as a draw comes through on a K 1, I'm not paying FICA tax on that 20, 000. Yep, still going to pay income tax, right? Correct. It's still income tax. You still have to show it for federal and state taxes. But it's not self employment income anymore. It's just because you're an owner of that business, you get the profits. Not paying that 15%. Mm hmm. Now, that at some point makes sense, and at some point it does not. So let me explain why, okay? And just to understand the numbers here, in this scenario, you're saving 15%. Laura, I don't remember like all the lines perfectly. Could you help me? If you know, great. If not, look it up. But the max
[00:16:00] income on Social Security is 150 something? I think it's 160 now. Is it? Okay. For 2023, yeah. So, let's say, in your example, we are under The social security maximum limit, but just for those who are trying to catch up on that particular topic, once you reach a certain amount of income, you no longer have to pay the 6. 2% for the social security and your employer no longer has to pay the 6. 2. What's the number of these days? 160, 200. Okay. So 160, let's just call it 160, 000 even just to make life simple for us, but once you cross the 160, 000 number, which is probably why I don't remember things right away. I'm like, Oh, you told me the exact one. I'm just going to go with what I want. Okay. So 160, 000, let's say someone makes 180, forget all this business talk. Let's just talk standard employee makes 180, 000. They pay. 6. 2% on the first 160, 200 and then anything from that mark up to 180, 000,
[00:17:00] they do not pay the 6. 2%. They just have to pay the Medicare. Medicare doesn't go away. It's 1. 45% on infinite amount of income. So for those people who are at lower incomes, by doing this S Corp, they're able to avoid the whole 15% on what comes through as a K 1. However, for most people, we actually see that the people who do this usually are making 150, 000 to 500, 000 a year and they are paying themselves something like 180, 000 anyway. And so they're already maxing out the social security limit. So The tax savings that they have for doing the S Corp is really only 1. 45% times 2, so 2. 9%. That's really all they're saving for most people. Again, if you're under that 160 line, then you're avoiding almost a full 15%. On the money that comes through as a K one in an S corp
[00:18:00] elected LLC. Wow. That was a mouthful. Start that over just so that everybody got it. You follow me. If you're an LLC and you choose to elect to be taxed as an S corp and you pay yourself a reasonable wage. Anything above and beyond that as profits comes through to you as a K 1, and if that amount is under 160, 000, you're avoiding about 15% on that, but if that amount goes over 160, 000, then you would have only avoided about 2. 9%. Okay, so if that's the case, the question is, well, when does it make sense to file the S Corp election and benefit from that? Now, Most accountants are going to charge you more money for doing an S Corp versus just an LLC because they have to file payroll taxes and have to actually do like mine does quarterly payroll. Reports and sends those to the IRS and it's just a little bit more work. And so I, I don't know the exact number, but the last time I checked, it seems like it's about
[00:19:00] 1, 200 more per year for the S Corp than for not having the S Corp. So if you are saving 3% and it costs you 1, 200 a year, Then you need to have more than 40, 000 go through as a K 1, and then you're finally breaking even at 40, 000. And that's if your income's over 160, 000. Yeah. Anyways. Yeah, so let's say somebody's making 200, 000 a year, and they are going to pay themselves 160, 000 as a W 2. Well, they maxed out the Social Security anyway. And they paid 40 as a draw, and that showed up as a K 1, and they didn't have to pay the 2. 9% on the 40. They basically broke even, because they had to pay their accountant probably another 1, 000 to 1, 200 to get all that work done anyway. But let's go through another example. So let's say someone, like you said, is making 100,
[00:20:00] 000. But let's say that they're able to say, well, my job, I'm only paying myself 25, 000 as a wage. So now we're talking about 75, 000. That is going through as a K 1. It's avoiding the 7. 65 times 2, right? So, we're avoiding 15. 3% on that. And it's 11, 000 in savings. So that's worth the 1, 200 to file as an escort. Exactly. So it's not always like, Oh, when you reach 200, 000, that's when you do it. It depends on what are you going to set as a reasonable wage. And what other income you have, let's say that you have two or three sources of income. One of them, you work for someone else and you have like a day job plus you have a side hustle. Well, your day job, let's say you make that 160. Well, then you're already pushing through the social security limits. And at that point, you basically want to pay yourself as little as possible as a wage on your LLC taxed as an S
[00:21:00] corp to have as much of it go K 1 as possible. Okay, and then a little bit of strategy around Social Security. So that's been our expertise at Capita. We spent a lot of time analyzing Social Security and One of the aspects of social security that most people mess up is not understanding that you do not get the same bang for the buck on lower income versus higher income social security taxes. Let me see if I can explain that. If someone makes 12, 000 a year and that's it, their social security payment in retirement, like that is incredibly low. They are going to replace like 90% of that for somebody who makes that little. In retirement, so they're basically getting almost their entire income back for someone who makes between that, let's say 12, 000 and 80, 000. So for the next 68, 000, they're going to give you back a little less than a third of that in
[00:22:00] retirement. So the next 60 to 70, 000. Not nearly as valuable as the first 12, 000 on your social security calculation for how much your benefit will be. We talked about this back in how your social security benefit is calculated, but now putting this in a context, and this is why, I mean, I know we're passionate about this, but this is why the Guided Path exists, right? Like, we taught you earlier how to understand how social security is calculated, because now we can explain, okay, social security is calculated by giving you 90% of the first. 12, 000 of your income, and then about a third of the next 60 to 70, 000 of your income. After that, it drops down to 15% up to the 160 mark. So in other words, after about 80, 000. You're really not getting much for the social security tax. It's still the same 6. 2% tax on both employer and employee side, but you're just not getting the benefit like you
[00:23:00] were with the first dollars paid in. So the reason I say all that is I get this all the time where somebody is a retiree is like two or three or four years away from retirement and they are paying themselves a wage of 120, 000 a year. And they're trying to figure out, well, should I pay myself 150 to push my social security benefit up? It's like, you're going to pay 12. 4% away in taxes of that extra 30, 000 a year. And they're barely going to give you anything for it because you are in the 15% of income being given back to you. And that's averaged over 35 years. It's just so small, it's going to be a buck or two on the monthly payment. And they're going to pay thousands in taxes for it. So anyway, I'll get off the soapbox. Lara's looking at me like, okay, okay, can we move on? But I'm just trying to explain to you guys. It's great. I'm not, I'm not. It's wonderful. Great information. It's a good thing we're not on
[00:24:00] video. We actually get this question a ton. You know, should I opt out? You know, some people have the opportunity to opt out of social security or with self employment, you know, should I opt back in so I can get these last few years, my income's higher now, is it worth it? And if you understand those bend points, it really might not be worth it for you. So think about the bend points a little bit. Think about it at about 12, 000 and then at about 80, 000 and then 160. Those are the lines. And depending on what other social security taxes you're paying with other employment, that's my situation. I have a regular income through Capita because I'm an employee here, but then I also have to choose how much I'm going to do through my S Corp as wages versus pass through income. And so I try to keep that Medicare tax as low as possible, basically. Okay, go ahead, we're just episode season two. Episode two is all about how your benefits calculated. So if you want to go back and listen to those different bend points, understand a little bit more how that works, you can go back and listen there. Thank you, Laura. That's great. Okay. So the main difference, in fact, I
[00:25:00] had six Or seven business partners that were starting a business. They were all tech people through another connection that we had. So very bright people. You could tell that they just were picking up on things really, really quick. And they had spent hours researching the difference between LLC taxed as partnership, LLC taxed as S Corp. And they were over the income limits for social security. And we went through just what we talked about. And the main CEO of the group said, hold on, you're just telling me it's the 3% difference. All of this is about just the 3% for the Medicare. And I'm like, yeah, that's basically it. And he was like, Oh my gosh, he was so frustrated that he'd spent so much time. Now to add on top of that, we will talk about this later. But when you go to sell a business because an S Corp has some tax benefits, the trade off is you cannot have like non people owning an S Corp. So it makes it difficult because some of the entities that exist like trusts or other LLCs that make estate planning
[00:26:00] really, really flexible and really, really, let's put it this way, like it makes it really advantageous for you to be able to get money out of your estate. In other words, if you're pretty sure you're going to sell your business. Then you probably shouldn't go the route of the S Corp if you're going to sell it within a reasonable amount of time. Yeah, I'm talking three, five years or a little bit more than that. If you're thinking I'm going to do this forever then sure, that's fine. Or if you don't think you're going to have something to sell, it's like a consultant business that's like, I'm just a consultant here, I'm just going to get income and then when I close up shop, I'm not selling it to anybody. Then sure, S Corps can work great. But just be careful. You need to understand, think with the end in mind a little bit and an LLC or a C corp could have more flexibility later on. Let's see. Is there anything else, Laura, that we may have missed? I think that covers this one. This is obviously episode one of this business owner's season. In episode two, we're talking all about small business retirement plans. This is a big question. You know, should I have a solo
[00:27:00] 401k or a SEP IRA? So we're going to go through that with you. Episode three is. Investing in your business and in your retirement, how to balance, you know, putting money into the business that can take a lot upfront, where should you be putting those dollars and still be okay for retirement? We talked about episode four, exiting your business, and then we'll wrap it up with episode five, having the right network, which is big. Yes, this is a good one. I feel like this is the area where people need help, but they oftentimes don't have a financial advisor as they're trying to grow their business because they don't either have assets or income to pay for a financial advisor. So I really hope these are useful to you. Then we'll do charitable giving and insurance and that would be season eight. That is crazy. All right. Next time. Thanks, everybody. This podcast is intended for informational purpose only and is not a substitute for personal advice from Capita. This is not a recommendation, offer or solicitation to
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