Choosing the Right Business Structure

Speaker 1 – 00:00
Welcome to EWA’s FinLit podcast. EWA is a fee only RIA based out of Pittsburgh, Pennsylvania. We hope all listeners
of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And
we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your
family and also save time.
Speaker 2 – 00:25
Foreign joined by Jameson Smith. We are talking about different business owner structures. So sole prop,
partnership, LLCs, S Corps, C Corps, we’re going to break down. If you’re a current business owner, is it worth
switching what kind of entity that you are and if you’re starting a business, you know what’s most appropriate. So
we’re going to break down the pros and cons. So Jameson, let’s start with the sole prop. This is the easiest one.
Walk us through the pros and cons.
Speaker 3 – 00:57
Yeah, simplest structure. This is if you’re you know, single owner, usually easy for or best for smaller businesses.
You’re a freelancer, you’re you know, doing some contracting work. Some of the pros, very easy to set up. There’s no
formal registration. You don’t need an EIN number. It just gets reported on your schedule C of your tax return. It’s
pass through taxation. So everything just flows to your tax return. There’s no corporate taxes or anything very low
administration meaning there’s no again no EIN number, no separate tax return, nothing like that. Some of the
downsides, you have unlimited personal liability so the owner is personally responsible for all debts and lawsuits.
Since it’s passing through to your personal tax return, it’s not its own entity. Can be harder to raise money.
Speaker 3 – 01:46
If you’re trying to go to a bank or an investor, they want structured entities generally. And then you pay self
employment taxes. So you know, we’ll talk about this in an S corp there’s a way to avoid some of that. But basically
you’re paying federal, state and then Social Security Medicare taxes and then.
Speaker 2 – 02:02
Local taxes and those Social Security Medicare packs you’re paying twice because you’re paying the employee side
and the employer side. So you know that’s that could be 15.3% all in up to the Social Security tax wage base which
what is that for 20, 25? It is 176,100, 176,100. So that’s a pretty hefty tax. 15.3% on the first 176 and then Social
Security 6.2 times 2. So 12.4. So that’s another 2.9 on that. You’re paying anything above that 176. That can be a
pretty hefty, you know, a sole prop can have a lot of liability plus it can be pretty hefty tax wise, federal, state, local.
But those FICA taxes can really get you and bite you real quick before. So who would a sole prop make sense for?
Speaker 3 – 03:00
A doctor that has some 1099 consulting income or anyone that’s doing any type of contracting work? You know,
maybe you’re an attorney and you’re doing some contracting legal work on the side.
Speaker 2 – 03:16
Yeah, those are good examples. I would, I would say so. One pro tip for if you’re a sole prop, at least establish a, you
know, an LLC that’s single member. This doesn’t change anything from a tax perspective. A sole prop and a single
member LLC are going to work the exact same way from a tax perspective. You’re going to hit with all the taxes you
just described. However, it’s going to release some of the liability, not some, a lot of the liability that you just
described as well. So if you’re a sole prop, if you’re a doctor doing you know, legal work on the side, medical
malpractice review, at least establish an LLC that you receive those payments through and that you’re operating
outside of your day job. Your W2 through the LLC not going to help you tax wise.
Speaker 2 – 03:56
But some of these other, you know, structures that we’re going to about to talk about do come up with some costs. I
mean there is a break even point of you have to have some meaningful income for it to make sense time wise,
money wise. For example, to go into an S Corp, especially with all the creative, you know, tax write offs. With a single
member LLC you can structure A401K through there, you can structure a cash balance pension plan, you can add
your kids on payroll, you can, you know, deduct car expenses, you can have a home office, there’s lots of
depreciation, there’s lots of things you can do to eliminate a lot of the income. And so what you’re paying taxes on
could be a lot less if you have those write off opportunities. So okay, number two would be an llc.
Speaker 2 – 04:45
But let’s specifically focus on a multi member LLC and let’s just use partnership LLC as an example of how this
works. So pros and cons, break it down for us.
Speaker 3 – 04:55
Yeah, pros, you have limited liability protection, you’re not personally liable for business debts pass through Taxation.
So again profits and losses flow to your personal tax turn still meaning really the difference is a C Corp has its own
corporate tax rate. So you avoid that flexible management meaning you can kind of pick and choose, you know how
you’re distributing profits. And you don’t have to have a formal like board or officers just have to be a structured. And
then some of the downsides again the self employment tax that we already talked about there’s some administrative
cost. You have to issue K1s. You have to have a corporate the business tax return and then yeah, basically
administrative and taxes are a little bit more complex.
Speaker 2 – 05:42
Absolutely. So from a taxation perspective for you know you’re gonna get taxed as a. You know it goes on Form
1065 for partnership. Each member that has equity inside the company is gonna get their K1. You still will have the
self employment tax unless you elect for an S corporation and then Pennsylvania state tax, local tax, etc. So this is
best for you know, multiple owned businesses that have multiple owners that want flexibility that pass through
taxation and let you know it does give a lot of flexibility to distribution. So for example an S corporation if you’re a.
Just to use a simple math, if you have two partners, one 60%, one’s 40% all profits or distributions have to go out. If a
hundred grand goes out of the business, 60 grand has to go to 60% owner.
Speaker 2 – 06:38
40 grand has to go to the 40% owner. And a partnership, let’s say the 40% owner did a ton more work. You could take
90,000 of that hundred and give it to the 40% owner, 10,000 give it to the 60%. So there’s more. There’s total flexibility
is from a distribution schedule in a partnership where the S corp is going to be exactly rigid based upon the
percentage of equity owned. Now the way around that with an S Corp would be you just, you know, bonus. But then
the bonuses become subject to the FICA taxes. The whole purpose of S Corp is to avoid the FICA taxes. So if you
want the flexibility, you’re going to pay the same or more in taxes.
Speaker 3 – 07:17
One thing if you’re owning real estate, don’t do it in an S Corp, do it in A&LLC or partnership. Why is that if you’re
going to hold the real estate long term and there’s I’m going to mess this up but there’s some tax benefits to the
basis and the S corp and when you sell it, if you sell it.
Speaker 2 – 07:32
All gets, you’re going to pay all the taxes all at once.
Speaker 3 – 07:35
Yeah. And with the S Corp in real estate, you’re going to pay the FICA taxes. Whereas if you have a partnership and
it’s not active income, you avoid this.
Speaker 2 – 07:46
Yeah, we did a podcast. There’s huge discrep. There’s huge differences. The real estate investor, if you’re active
versus passive, active being better in this. In the event that you can offset W2 wages and your active income.
Passive, you know, being better for what you just described, not as beneficial to offset. You can offset active income,
but if you have lots of other passive income that the two offset each other one for one. Passive losses offset
passive gains. So okay, well let’s hit on S Corps and then C Corps last. So S Corps, an LLC can opt as an S Corp, or
you could just do an S Corp outright. The pros, there’s limited liabilities. You do avoid double taxation like you’d have
in a C Corp. Only salaries are subject to Social Security and Medicare taxes.
Speaker 2 – 08:34
So for example, if you had a business, half million dollars of profit, an S corp, you could do $100,000 as a W2,
$400,000 as a distribution. That $400,000 would avoid, you know, Social Security taxes. You’d avoid Medicare taxes
as well. So there are, there is a reasonable you. If you get audited by the irs, you need to make sure that salary is
reasonable. So if you’re a doctor, that would be normally making half a million dollars a year, you can’t pay yourself a
salary of 100,000. You have to do something reasonable. On average, maybe it’s 300,000. If you’re only distributing
200,000, you have to realize, okay, I’ve already capped out my Social Security chunk of that Medicare or that FICA
tax, the 12.4%. I’m not saving anything. I’m just saving 2.9%. So 2.9% of the 200 grand in that example will be 5,800
bucks.
Speaker 2 – 09:26
So I’m saving $5,800 being an S corp over a, you know, just regular llc. What is my tax fees? I have to now run payroll
as an S corp tax fees, I have to keep a balance sheet. Are all of those things worth a $5,000 tax savings? And so we
see a lot of group think in S Corp. So, you know, for example, one doctor opens up an escort. Like the whole practice,
all the private practice positions will do it. Not a huge difference. If you’re doing all the tax strategies, you should be
doing a 401k a pension plan, you know, depreciation, kids on payroll if they’re working for your business, you’re
actually in a lot of cases better off just being an LLC than an S Corp. Net of your time tax.
Speaker 2 – 10:12
And it’s a lot more simple because you don’t need to run payroll. Everything will run through a schedule C versus
needing a separate business tax return. It can just flow through your personal tax return on a schedule C. So a lot
more simplicity in llc. So at S Corp we see it a lot for single owned business owners. But you know, general speaking,
I would say, you know, you have to have a benefit of, let’s say 15,000 plus of tax savings for it to make sense to add
that level of complexity in your life. If you’re making a half million dollars a year.
Speaker 3 – 10:43
Yeah, and harder for like a professional service, like a doctor or an attorney, because like you said, you have to pay
yourself a reasonable salary. But if you own a, I don’t know what’s a good example, like a solar company and you can
pay yourself a salary of 100 grand for running the business. There’s no, like, there may not be a. The irs, it’s very easy
for them to say what a doctor’s salary should be. You know, if you’re a cardiologist and you’re paying yourself 100
grand, they’re gonna just look at what other cardiologists make and that’s not reasonable. But if you’re in a, you
know, a business outside of that solar example, you can get away with a lower salary generally and then have
everything else flow through the S dividend.
Speaker 2 – 11:21
Absolutely. Okay, for, so for taxes, the profits all pass through the shareholders. Self employment tax on salaries, not
distributions. Pennsylvania tax would still hit. Local tax in certain states would still hit. And you do need to, in
Pennsylvania you need to file a PA corporate return RCT101 as well. So remember, there’s that extra level of
complexity. So generally speaking, S Corps are, you know, significant profits. But you want to minimize that self
employment tax. Now again, the lower you take your W2 to save those FICA taxes, the lower your ability is to put into
a 401k or pension plan because those are all based upon a W2 versus. If you’re an LLC, the IRS will let you look for a
401. You can, you know, the 401k calculations work on the first 345,000 of your earnings.
Speaker 2 – 12:13
So typically as long as you show 345 in an LLC, you’re going to show everything versus an S Corp. It’s your choice on
how much you show as a W2, but if you lower that to 100, okay great, now we’re saving maybe 10, 15, 20 grand. But
now we’re losing 50 grand of what we’d get back in a tax deduction from setting up a 401k, maxing it out fully, a cash
balance, pension plan, et cetera. So depending on your overall goals, again, I think S Corps are becoming less and
less favorable in the context of someone that’s implementing all these other tax strategies. If you’re just paying
yourself and want to minimize taxes and not doing any retirement savings, not doing any other advanced strategies,
then sure, an S Corp could make sense.
Speaker 2 – 12:53
You have to have a good cpa, bookkeeper, et cetera, to make sure you’re hitting everything. So okay, last but not
least, C corporations. So really a C corporation for small business, medium business, you know, something that’s not
publicly traded. Small business owners generally wouldn’t see a C Corp with the exception of if you are within, you
know, five to 10 years of selling your business, a C corp, it would be an absolute no brainer based upon a Rule 1202
QSBS where you can exclude up to $10 million or 10x your original investment, your basis tax free and capital gain.
So at that point, right now $10 million, the highest tax rate of capital gains would be a $2.38 million federal tax
savings. So this is the basically the sole reason our listener base would want to consider a C Corp.
Speaker 2 – 13:41
Someone that has a 20, 30, 40 year Runway, a small business owner, the tech get tech kid, 25 years old, that’s
blowing something up. They have a 25 year Runway. You’d want to, you know, be an S Corp or an LLC. But for
someone that’s five years within. We just recorded a podcast on the QSPs, so please reference that. That’d be the
main reason why you want to do a C Corp. So with that being said, Jameson, give us the pros and cons just in
general of the C Corp with the qsbs obviously being the big pro.
Speaker 3 – 14:08
Yeah, limited liability protections is the strongest legal protection for owners. Basically if you got sued, they’re suing
the company, not you as a person. Unlimited growth potential so you can have unlimited amount of shareholders.
Issue multiple stock classes. It’s much more attractive if you’re raising money for investors. Lower self employment
taxes because if you take a W2 out, if you’re active in the business, you’ll pay all those taxes. But if you’re not the
profits of the business pay a corporate tax rate, it’s currently 21% but then anything that you take out gets taxed at
the dividend rate 0 to 20%. So you would avoid those self employment taxes. But again you’re kind of getting double
taxed with the corporate tax rate. Some of the downsides, double taxation.
Speaker 3 – 14:58
Like I said, you pay the corporate tax rate plus whatever you take out you pay taxes on. Complex and expensive. You
have to have a board of directors annual meetings. There has to be more structure within the entity and then this is
important. In the state of Pennsylvania it’s one of the highest C corp tax rates. I think it’s like 8 point something
percent. So you know, instead of a normal, if you have an S corp and you’re paying 3.07 on a state level or an LLC
partnership, you’re paying 3.07. You know this, you could pay percent paying higher state taxes in state of
Pennsylvania. And that’s obviously state spit state specific depending on what state you’re in.
Speaker 2 – 15:36
Awesome. Well that’s a general Overview of the four business structures we covered. SOLE, PROP, LLCs,
partnerships, specifically S Corps and then C Corps. But feel free to reach out if you have any questions. If you’re a
business owner that’s planning on selling, if you’re a business owner that’s planning on evaluating whether you’re in
the right business structure and you need to convert, there’s rules. If you’re converting to an S or out of an S, there’s
certain rules that you have to follow. And then if you’re starting a new business or if you’re a doctor, a high income
earner that has some side business, you’re wondering what to do with that, how to structure that side business.
We’re happy to help. Feel free to reach out with any questions.
Speaker 1 – 16:11
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Speaker 2 – 16:26
Members that would also find this beneficial.
Speaker 1 – 16:29
Thank you very much.