Purposes of a company and the tax consequences

Some clients want to form a company to do business and ask me what forms of business they should consider, and the tax consequences. This post addresses this issue.

Purposes of forming a company

The following are the four most important reasons why people might form a company.

Organization: First and foremost, forming a company can provide a legal and organizational framework that can help to streamline and manage the business’s activities more effectively. A company can have a formal organizational structure with different levels of management and decision-making authority. This can help to clarify roles and responsibilities within the business and make it easier to coordinate activities.
Professional image: A company is often seen as more credible than a sole proprietorship or partnership, which can be helpful for attracting customers and partners. A company may also be seen as more stable and long-lasting than a sole proprietorship or partnership, which can be an advantage for building relationships with customers, suppliers, and other stakeholders.
Limited liability: A company is a separate legal entity from its owners, so the owners are generally not personally liable for the company’s debts or legal problems if you do not comingle funds between business and personal, and exercise other precautions. However the limited liability offered by an LLC does not replace good business practice and adequate insurance coverage.
Succession: A company can continue to operate even if the original owners or founders of the company are no longer involved in the business for one reason or the other.

Common types of business structures

With these purposes in mind, a formal review of the most common types of business structures in the United States is in order.

Sole proprietorship: This is the simplest and most common type of business structure. As a sole proprietor, you own and operate your business by yourself, and you are personally responsible for all of the debts and obligations of the business.
Partnership: A partnership is a business structure in which two or more individuals own and operate the business together. There are two main types of partnerships: general partnerships and limited partnerships. In a general partnership, all partners are personally responsible for the debts and obligations of the business. In a limited partnership, there are both general partners and limited partners. The general partners are personally responsible for the debts and obligations of the business, while the limited partners have limited liability.
Corporation: A corporation is a legal entity that is separate from its owners. This means that the corporation itself, rather than the owners, is responsible for the debts and obligations of the business. There are two main types of corporations: C corporations and S corporations. C corporations are taxed at the corporate level, while S corporations are pass-through entities, which means that the income of the corporation is passed through to the individual owners and taxed at the individual level.
Limited liability company (LLC): An LLC is a hybrid business structure that combines features of both a corporation and a partnership. Like a corporation, an LLC offers its owners limited liability protection, which means that they are not personally responsible for the debts and obligations of the business. However, like a partnership, an LLC is a pass-through entity, which means that the income of the business is passed through to the individual owners and taxed at the individual level.

Ways to file taxes for an LLC

Among the four most common business forms, the LLC is the most flexible in that it meets all four purposes of establishing a business: organization, professional image, liability, succession, and it has an option for how it files its taxes: as a sole proprietorship, a partnership, an S Corp, or a C Corp, as depicted in the following ASCII art.

You --> Sole Proprietor ------> Schedule C ------> Form 1040 (Personal Tax)
 |    (Self Employed)             ^                  |       |       ^
 |                           Net Income <-- FICA --> K1      ^       |
 |                                |                  ^       |       ^
 \-----> LLC --> Sole Proprietor -/                  |    W2 + K1    |
          |      (Default for Single Member LLC)     ^       | ^ no  ^
          |                                          |       ^ FICA  |
          |  --> Partnership Form 1065 --------------/       |       ^
          |      (Default for Multi Member LLC)              ^       |
          |                                                  |       ^
          \  --> S Corp Form 1120S (Pass-Thru) --------------/       |
          |      (Domestic shareholders <= 100)                   W2 + 1099-DIV
          |                                                          | ^ no
          \  --> C Corp Form 1120 (Business Tax) -------------------/  FICA
                 (Double Tax)

You do not need to form an LLC to do business, you can always operate as a sole proprietor (self-employed), and report your business income and expenses on Schedule C (Profit or Loss From Business) which will flow to the main form 1040 where personal tax will be computed.

If you have set up an LLC and if it is a single-member LLC, it defaults to a sole proprietorship for filing taxes. You report income and expenses directly on Schedule C.

For a multi-member LLC, it defaults to a partnership for filing taxes. You need to file a partnership return to report income and expenses, and the result is passed through to individuals through Form K-1 generated as part of the partnership return.

A multi-member LLC consisting of husband and wife can choose to file two Schedule C’s in a community state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), eliminating the burden to file a separate partnership return.

An LLC can elect to file as a corporation, a C-Corp, or an S-Corp, to accommodate more complex income and expense data structure. The S Corp has the advantage that it passes its income to the individual to be taxed only at the personal level, while a C-Corp incurs double taxation: when income is generated at the Corp level, and when it is distributed to the shareholders as dividends.

However, you have the meet the following requirements to be an S Corp:

Be a domestic corporation.
Have only allowable shareholders.
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders.
Have no more than 100 shareholders.
Have only one class of stock.
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

You use Form 8832 to elect to be treated as a C-corporation, and use Form 2553 to elect to be treated as an S Corporation. Filing as a corporation necessitates maintaining a payroll, which comes with a significant number of compliance requirements. Using VA as an example, the monthly, quarterly, and yearly tasks include:

US: Quarterly Form 941 and payments on 4/30, 7/31, 10/31, and 01/31.
VA: Tax Withholding (VA-5) done quarterly, monthly, or seasonal filing depending on income.
VA: Employment Commission (EC) Employer’s Quarterly Tax Report (FC-20)
VA: Employment Commission (EC) Employer’s Quarterly Payroll Report (FC-21)
–
US: Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return)
VA: VA-6 (Employer’s Annual or Final Summary of Virginia Income Tax Withheld)
US: Form W2 for employees.
US: Form 1099 for non-employee if any.
US: 401K if any.
–
US: Form 1120S (S-Corporation)
VA: Form 502 (Pass-Through Entity)

I strongly recommend finding a good payroll company to handle these tasks for you, and remember “A domestic corporation (including a Subchapter S corporation) must file an income tax return whether it has taxable income or not, unless it’s exempt from filing under section 501.” according to this IRS website.

Filing as Sole Proprietorship versus S-Corp

A major difference between filing as a sole proprietorship and S-Corp is that:

The Sole Proprietorship only has one class of income, the net business income, i.e. gross receipt less expenses, which directly report on Schedule C.

There are special cases where FICA tax can be escaped, for example, nonresidents being retreated a sole proprietor receiving Form 1099-NEC, but in general Schedule C is not the place to separate wages and business profit.
The S-Corp allows different types of income to be passed through to personal return, and each type retains its characteristics. For example, you can have wages paid to yourself through W-2 and oridinary business income distributed through [Schedule K-1][k1].

As a result of this difference, it creates a tax disparity on FICA (Federal Insurance Contributions Act) tax.

The FICA tax is a combination of Social Security and Medicare taxes. It is referred to as self-employment tax in the context of a sole proprietorship and as payroll tax in the context of W-2 income. It is a tax that is paid by both employees and employers. The tax funds Social Security and Medicare. The current rate for Social Security is 12.4% of the employee’s wages, up to a maximum wage base of $142,800 for 2021. The rate for Medicare is 2.9% of all wages, with no maximum wage base. The employer and the employee each pays half of the amount. The self-employed pays the full amount since she is both the employer and the employee.

Since the self-employed income has only one class, you pay the FICA taxes on the entire net income if you file as a sole proprietorship. While filing as S-Corp, only the wages paid to the owner shareholder are subject to FICA tax, not the K-1 distribution. This seems to indicate filing as S-Corp has a huge advantage, and many accounts advertise this as a tax-saving strategy. While this has a bit of truth at the low income level, the benefit is limited or even get reversed at high income level due to the following factors:

The social security tax, which is the larger portion of the FICA taxes, has an upper limit per person, so how much you could “save” is capped.
Generally you cannot distribute the entire business income because the IRS requires that you pay yourself a reasonable compensation, so the K-1 distribution amount and the tax savings is limited. When the wages reached the maximum amount ($142,800 for 2021), the savings on social security tax vanishes.

How much is a reasonable amount depends on the nature of your job, and the field of your job. For example, when you are in the software consulting business, and you get paid hourly, then 100% of the income is earned income without profit. On the other hand, when you write an app for sale, after paying yourself “reasonable” wages, the surplus is the profit.
At a high-income level ($200,000 for single status in the year 2021), the K-1 distribution is subject to 3.8% Net Investment Income Tax (Form 8960), which is precisely the 2.9% regular medicare tax plus 0.9% Additional Medicare Tax (Form 8959), so the savings on the medicare tax disappears as well at the high-income level.
The wages you pay yourself does not enjoy a 20% Qualified Business Income Deduction QBID allowed on the entire net self employment income, this offsets or overturns the potentional benefit via K-1 distribution. By the way, the QBID was established by the Tax Cuts and Jobs Act of 2017 (TCJA), which is set to expire in 2025.
When you have wages from a company that is not your own and has reached the maximum wage base for social security tax, the disparity in favor of self-employment magnifies. This is because the social security part of self-employment tax completely vanishes on both the employee and employer side as seen on line 8a of Schedule SE, while the payroll tax continues on the employer side when you pay yourself through an S-Corp. This makes sense as the S-Corp is a separate entity and has to reach its own maximum wage base.

By the way, even the self-employed does not pay the social security tax, the law still allows the full 7.65% deduction, as this is hard-coded in line 4a of Schedule SE. This is in favor of filing as self-employed in a lesser extent.

I feel the disparities between filing as self employed and as S-Corp are defects in the law rather than designed features, and that Congress is aware of them and try to them whenever they have an opportunity. The Net Investment Income Tax (NIIT) was implemented as part of the Affordable Care Act (ACA), also known as Obamacare, which was signed into law on March 23, 2010, and went into effect on January 1, 2013. It fixed the defect that K-1 distribution skips the FICA taxes at the high-income end, and now all business income, no matter it is self employment income, S-Corp wages, or K-1 distribution, pays the same amount of FICA taxes at the high-income level. Since the NIIT is not a payroll deduction, K-1 distribution has a small advantage.

Tax consequences: Numerical result

There are rarely analytical solutions in tax computations, let us do some quantitative analysis to visualize the effects. In the examples provided below, we are operating under the assumption that the applicable tax year is 2021. The taxpayer in question is single, has no dependents, and possesses no additional sources of income other than those specified below.

Seq. No	Filing As	Other Income	Your Income	Wages Paid	K-1 distr.	SS Tax Employer	SS Tax Employee	Med. Tax Employer	Med. Tax Employee	Other Tax	Income Tax	Total
1a	Self Employed	$0	$200,000	$0	$0	$8,854	$8,854	$2,678	$2,678	$0	$29,188	$52,252
1b	S-Corp 50% wages	$0	$200,000	$100,000	$92,350	$6,200	$6,200	$1,450	$1,450	$0	$34,214	$49,514
1c	S-Corp 100% wages	$0	$200,000	$188,414	$0	$8,854	$8,854	$2,732	$2,732	$0	$37,103	$60,275
2a	Self Employed	$150,000	$200,000	$0	$0	$0	$0	$2,678	$2,678	$1,212	$91,714	$98,282
2b	S-Corp 50% wages	$150,000	$200,000	$100,000	$92,350	$0	$6,200	$1,450	$1,450	$3,959	$89,974	$103,033
2c	S-Corp 100% wages	$150,000	$200,000	$188,414	$0	$0	$8,854	$2,732	$2,732	$1,246	$88,597	$104,161

Notes:

1a: The taxes paid entirely as self-employment income, this serves a base model for comparison.
1b: K-1 distribution is reduced by wages paid, employer portion of FICA taxes. There is a “savings” on the skipped FICA taxes on K-1 distribution in this low-end model, which was offset of the lack QBID on wages, it results in a small “savings” ($2,734).
1c: K-1 distribution is zero after reducing wages paid, and employer portion of FICA taxes. You pay more taxes ($8,195) mainly because the wages paid do not have qualified business income deductions.
2a: Since taxes are paid on the entire self-employment income, there is only little FICA taxes recapture on Additional Medicare Tax.
2b: K-1 distribution is reduced by wages paid, employer portion of FICA taxes. Since the K-1 distribution skipped the payroll taxes, the FICA taxes are recaptured in other taxes (Additional Medicare Tax and NIIT Tax). You pay more taxes at the high-income level ($4,751) mainly because the S-Corp as a separate entity has to pay social security tax ($6,200).
2c: K-1 distribution is zero after reducing wages paid, and employer portion of FICA taxes. Since the FICA taxes are capped at a high-income level, the total taxes paid is almost the same. The small difference between [2b] and [2c] comes from that the FICA taxes paid through payroll are a deduction while Other Taxes are not.

Tax consequences: Analytical solution

Although there is no analytical solution in general, by carefully choosing a set of boundary conditions, we can come up with some examples. Let us choose two examples where we can compute taxes with simple arithmetics.

Example 1: Low end model

Year: 2021
Filing status: Single
W2 wages: 101,000
Net business income: I=40,000
Percentage of wages paid: r

Under this boundary condition, the tax rate for business income is a flat 24%, and the FICA taxes are not capped.

When filing as a sole proprietor, the total tax on the business income is:

$\begin{align*} \textrm{Tax(Self)} &= I*92.35%*15.3% + I*(1-\frac{92.35%*15.3%}{2})*80%*24% \\ &= 0.3197*I \end{align*}$

When filing as an S-Corp paying $I*r$ as wages, the total tax on the business income is:

$\begin{align*} \textrm{Tax(S-Corp)} &= I*r*15.3% + I*r*24% + (I-I*r-\frac{I*r*15.3%}{2})*80%*24% \\ &= (0.192 + 0.186312*r)*I \end{align*}$

Equate the two expressions and solve for $r$ , we get $r=68.54%$ . This means, if more than 68.54% of the income is wage, then you pay more taxes, the 68.54% is the break-even point. To visualize the differences, let us tabulate the result:

r (% wages paid)	Tax as S-Corp	Tax as Self Employed	Diff
00.00%	$7,680	$12,788	-$5,108
25.00%	$9,543	$12,788	-$3,245
50.00%	$11,406	$12,788	-$1,382
68.54%	$12,788	$12,788	$0
75.00%	$13,269	$12,788	$481
92.89%	$14,603	$12,788	$1815

The $5,108 savings in this example is the theoretical maximum that you can “save”, but it can hardly be realized in reality because as aforementioned the IRS does require you to pay a “reasonable” salary.

Example 2: High-end model

In this example, we assume the taxpayer has other income high enough that:

The social security tax maximized
The QBID phased out
The marginal rate reached the highest 37%

Specifically, we assume:

Year: 2021
Filing status: Single
W2 wages: 550,000
Net business income: I=40,000
Percentage of wages paid: r

When filing as a sole proprietor, the total tax on the business income is:

$\begin{align*} \textrm{Tax(Self)} &= I*92.35%*(2.9% + 0.9%) + I*(1-\frac{92.35%*2.9%}{2})*37% \\ &= 0.4001384225*I \end{align*}$

When filing as an S-Corp paying $I*r$ as wages, the total tax on the business income is:

$\begin{align*} \textrm{Tax(S-Corp)} &= I*r*(7.65% + 2.9%+37%+0.9%)+I*(1-r-\frac{r*15.3%}{2})*(37%+3.8%) \\ &= (0.408 + 0.045288*r)*I \end{align*}$

At high-income level, both filing taxes as self-employed or S-Corp consists of:

The marginal rate of 37%
The base and additional Medicare tax of 3.8%

Any small variations in these amounts are due to differences in how FICA taxes are treated as deductions.

However there is one big difference that it incurs an additional employer portion of the 7.65% of the social security tax when you pay yourself through S-Corp, and that is why the more you pay yourself, the more the tax amount, as shown in the formula and tabulated below:

r (% wages paid)	Tax as S-Corp	Tax as Self Employed	Diff
00.00%	$16,320	$16,006	$314
25.00%	$16,773	$16,006	$767
50.00%	$17,226	$16,006	$1,220
75.00%	$17,679	$16,006	$1,673
92.89%	$18,003	$16,006	$1,997

Final word

Generally speaking, when an item is tax deductible, it is deductible if you have set up a company or you do not set up a company; if you file as a sole proprietorship or you file as an S-Corp. It is not the case that when you set up a company, a non-deductible item magically becomes deductible. A company is not an omnipotent basket that you can throw anything into it.

“Premature optimization is the root of all evil”. I have seen too many businesses without activities have to file empty business returns and eventually decided to close. I would recommend concentrating on improve your services, your products, and increase your client base. Remember that if you have no client, there will be nobody there to sue you, and you do not need the legal protection at the time.

If you do decide to form a company, and to file taxes as a Corporation, please carefully review the pro and cons. I hope this post can be of help for you to make a good decision.