So you are ready to incorporate your new biz? Great.
You’ve probably read a million blog posts, Googled “LLC vs S-Corp” or “S-Corp vs C-Corp” a dozen times, asked your business owner friends, and maybe even consulted a CPA. Great.
I this post I’m going to share with you a lesson I learned regarding business entities that created an unexpected tax liability.
THE CONTENT IN THIS POST IS MY OPINION BASED ON MY EXPERIENCES AND SHOULD NOT BE TAKEN AS FINANCIAL ADVICE. CONSULT YOUR CPA OR A CERTIFIED TAX PLANNING PROFESSION AND YOUR LAWYER.
In my opinion, the number one thing you need to be planning for with your business entity is what happens if it is successful. You might be thinking “well duh.”
Tax planning is easy when you don’t make any money.
But what happens when a company makes a lot of money? It’s a pretty easy question to answer, there are only 3 options:
- The owners take money out of the company and do whatever they want with it personally, like buy Lamborghinis, bigger houses or vacations.
- The owners leave money in the business and use the money to grow the business.
- Some combination of #1 and #2.
Let’s look at a scenario #2 because that is probably the most likely scenario for a first year … I’m using Oregon tax percentages so the totals might seem high if you are in a different state that has lower income taxes.
Let’s say you start a company and have a good first year. Your business grows, you make money. You pay yourself a reasonable salary as an employee (something you should be doing regardless of the entity) and pay your employees and expenses. At the end of the year you have an extra $100K in the bank. Most people would consider this a good first year.
Now what are you going to do with that extra $100K?
If you are like most people you say “I’m going to keep it in the company for operation and expansion”.
Here’s the snag. If you are using a pass-through entity such as a LLC or S-Corp that money you are leaving in the company (retained earnings) is personally taxable to you in proportion to your ownership of the corporation.
Said another way, if the company has a profit of $100K and you decide to leave the money in the corporation for next year’s growth, you’re going to be personally paying taxes on your share of the $100k.
Here is why that is particularly nasty. #1 you are paying taxes on money you didn’t actually receive. #2 you will likely underestimate the amount of taxes to withhold.
Let’s say you paid yourself a small but reasonable salary as a business owner – $40K. Your payroll software will calculate tax withholding as if you made $40K. But when you file your business return for your LLC or S-Corp, your share of the $100K gets passed thru to you personally as income.
Let’s say you are a 50% partner. To the tax man you did not make $40K you made $90K.
So now here is what your tax situation looks like:
You made $40K as an employee and withheld the appropriate amount thru your payroll.
You have pass-through income on $50k, of which you have not actually received and of which you owe taxes on.
Now what would probably happen is you would take out an extra $20K from the company as a distribution (dividend and distribution is not the same, ask your tax advisor). So you won’t go bankrupt after all. But that $100K you thought you had is now $60K (you’ll have to give the other 50% shareholder his share too).
It’s my opinion that if you plan to reinvest your earnings in growing your company, you might strongly consider C-Corp.
If you plan to take as much money out of your company as possible, then LLC or S-Corp may suit you just fine.