No matter where you are in your business building journey, it’s smart to occasionally re-evaluate past decisions. Now, I am not talking about second-guessing some of your youthful choices and occasional indiscretions…What I am talking about are the decisions you’ve made about your entity structure.
In my experience, most entrepreneurs don’t start their businesses under ideal circumstances. Yes, in a perfect world, one would have all the time in the world to consider options, weigh the pros and the cons, consult with an attorney and a tax planning professional, and perhaps even look into a crystal ball to see where the business would be 5–7 years down the road. And if you did all that, congratulations! You are a unicorn, and you probably don’t need the rest of this article.
But for the rest of us, there’s an opportunity to do better now. And sometimes, that means re-considering how you have structured your business — and whether that choice still makes sense today.
As you scroll below, you will see outlines of several possible shifts in entity structure, along with their resulting tax treatments. Some of these strategies can save the business significant money. But before we get there, I want to mention the most important consideration.
Entity structure choice is a complex decision that should be made for good business reasons.
In other words, don’t let the tax tail wag the business dog. Sure, saving money on taxes is great. However, be sure that you have also thought about the administrative burden, the number of owners and their compensation, access to financing, and possible exit strategy. And, of course, talk to an attorney and a tax specialist to consider both federal and state law consequences of your decision.
With that said, here are two possible shifts to consider.
Entity Structure Strategy: Schedule C to S-Corp
In simplest terms, a sole proprietor who is operating under an LLC can opt to be treated as an S-Corp for tax purposes.
Advantages:
- Eliminate 15.3% self-employment tax that applies to non-wage distributions in current and future years. Limitations and conditions apply.
Caution:
- S-Corp shareholders are required to receive “reasonable compensation” from the S-Corp. While some business owners have gotten away with skipping this requirement in the past, the IRS has been focusing on enforcing this recently.
Savings ranges:
- $3,000–$15,000+
Entity Structure Strategy: S-Corp to C-Corp
If your business is aggressively reinvesting sizable profits into the business (as opposed to distributing those profits to owners), then a C-Corp may be more beneficial than an S-Corp.
Advantages:
- Corporate tax rate is a flat 21%, whereas individual tax rates that apply to pass-through income are likely higher.
- Ability to raise capital by adding shareholders beyond 100.
- Access to a higher number of tax-friendly fringe benefits.
Caution:
- Double taxation on distributions.
- Shareholders cannot deduct business losses on individual tax returns.
Savings range:
- $5,000+
Good Business: Choosing Your Entity Structure
Making the wrong choice about business entity structure can cost you thousands in taxes. However, changing entity structure just to get tax benefits can also have negative side effects.
Make sure to research and understand the full scope of consequences, from administrative burdens to meeting requirements, distribution limitations, and record keeping. Additionally, remember that there must be a legitimate business purpose behind what you do. If entity structure does not have a business purpose other than tax avoidance, then the IRS can disregard it and deny you any benefits that would have resulted.
Finally, remember that every business entity structure has its benefits. The ultimate choice is about balancing those benefits with the burdens on the other side — and being aware of other business and legal considerations.
If you are wondering if your choice of entity structure still makes sense, reach out to our team at TreMonte. We are here to help you think through the decision and whether making a switch can be a net-positive for your situation.
Photo by Sean Pollock on Unsplash