When planning for the future, owner-employees face a variety of distinctive tax challenges and advantages, depending on whether their business is structured as a partnership, limited liability company (LLC) or corporation. It is important to be aware of how the divergent entity types may apply to your particular situation.
Partnerships and LLCs
If you are a partner in a partnership or a member of an LLC that has elected to be disregarded or treated as a partnership, the entity’s income flows through to you (as does its deductions). This income will likely be subject to self-employment taxes — even if the income is not actually distributed to you. This means your employment tax liability typically doubles because you must pay both the employee and employer portions of these taxes.
Fortunately, the employer portion of self-employment taxes paid (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above-the-line, thus reducing adjusted gross income.
But flow-through income may not be subject to self-employment taxes if you are a limited partner or the LLC member equivalent. Flow-through income may be subject to the additional 0.9% Medicare tax on earned income or the 3.8% net investment income tax (NIIT), depending on the situation.
S and C corporations
For S corporations, even though the entity’s income flows through to you for income tax purposes, only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. Keeping your salary relatively, but not unreasonably, low and increasing your distributions of company income (which generally is not taxed at the corporate level or subject to employment taxes) can reduce these taxes. The 3.8% NIIT may also apply.
In the case of C corporations, the entity’s income is taxed at the corporate level and only income you receive as salary is subject to employment taxes, and, if applicable, the 0.9% Medicare tax. Nevertheless, if the overall tax paid by both the corporation and you would be less, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which are not deductible at the corporate level, are taxed at the shareholder level and may be subject to the 3.8% NIIT).
How to decide
The entity type that best serves your company’s needs may change over time as you move through divergent business life-cycle stages. Consequently, a routine review of your entity type is advised. Please contact us for help identifying the ideal entity type, or other business strategies, appropriate for your situation.