Question: I have a services-based business in the Seattle-Bellevue area with three employees. What type of entity should I adopt in order to minimize my tax obligations? Right now, I am a sole proprietor. My previous tax accountant said I would save money as a limited liability company (LLC).
Answer: As a sole proprietor, 100% of your profits are subject to self-employment taxes. The self-employment tax is 15.3% of all profits up to $137,700 (for 2020).
Owners of limited liability companies (LLCs) who are active in the company operations are generally subject to the same self-employment tax.
Your business can reduce its self-employment tax obligation by creating an S-corporation. S-corporation profits are not subject to employment taxes. The owners’ wages, however, will be subject to employment taxes like any other employee.
Many S-corporation owners don’t pay wages to themselves for this reason. They take profit distributions only, thereby avoiding all employment taxes. These taxpayers, however, are at risk of paying penalties if they are audited by the IRS. The IRS requires that S-corporation owners who operate their business pay themselves a “reasonable wage.”
Now you realize that you can maximize your tax savings by creating an S-corporation and paying yourself the smallest wage that qualifies as “reasonable.” So what is reasonable? The IRS does not give specific figures. Also, there is very little case law to provide guidance by example. There are factors that are considered in determining reasonable wage.
Courts would look at the work done by the owner compared to other persons performing similar duties. Courts will also look at the capital contribution by owners. If profits are attributable to capital investments rather than the owner’s efforts, a greater allocation toward profit distribution is warranted. Also, if profits are attributable to the leverage offered by employees, rather than the owner’s own professional services, again, a greater allocation toward profit distribution is warranted.
Assuming that $50,000 per year is a reasonable salary, you could save $9,451 in employment taxes by creating the S-corporation and paying yourself this wage from the $200,000 profit.
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