Incorporating is one of our favorite services, not only for the tax savings it provides those who are self-employed, but also for the asset protection it offers those with passive real estate investments or one-off productions in the entertainment industry.
Before we dive into the benefits of an S-Corporation, let’s first understand each type of business entity:
- S-Corporation: Entity used to assist self-employed individuals transition from small to medium-sized business structures. The only entity that allows the self-employed to reduce social security and Medicare tax (SE tax). An S Corporation can also be an LLC electing to be taxed as an S-Corporation.
- C-Corporation: Large Business entity. Over 100 shareholders, north of $10 million in gross revenue. The C-Corporation is the only entity that allows 100% of medical expenses as deduction
- LLC: The LLC is the best entity for protecting large depreciable assets. Best for rental properties (not for 3+ property flipping businesses). Limits Liability on assets and business structures.
We recommend anyone earning $50,000 or more through self-employed income (whether paid as a 1099 or through your own business) to speak with their tax preparer about the benefits of an S-Corporation. The S-Corporation allows self-employed individuals to protect their business separately from personal assets. Along with greater asset protection, the self-employed individual (filing as an S-Corporation) may receive a benefit from the Reasonable Salary Requirement.
Neither the C-Corporation or the LLC provide tax benefits to the self-employed individual. The S-Corporation allows self-employed individuals to pay themselves reasonable salaries, rather than paying 100% of the profit and payroll; as low as 40% of the annual net profit. This allows the taxpayer to avoid, not evade, paying social security and Medicare tax on 60% of their annual profit. Although some taxpayers may see this as a detriment to their social security benefits, the taxpayer will potentially save thousands of unnecessary social security and Medicare tax, allowing them to redirect these savings into their own retirement plans.
This reasonable salary calculation must be the design of a licensed, experienced tax professional. If the reasonable salary percent is not met, the IRS and State agencies may step in and claim that the corporation is not fulfilling its duty as a legal entity to pay its primary shareholder a reasonable employment salary. This would further result in underpayment penalties and possible civil assessments.
While there is a recurring expense to the state of California to own and operate such an entity, the benefits easily outweigh the costs in most circumstances. The fee you pay to any state agency is a federal tax deduction. Based on what bracket you individually file in, this particular payment, although an expense, could return you anywhere from 10%- 50% tax savings. Your tax preparer will be more than happy to assist you in determining whether incorporating is right for you.
What About the Self-Employed?
For the self-employed, the pass-through nature of the S-Corp can create tax savings that are not possible as an individual. All Sole Proprietor business owners are subject to federal, state and Self Employment tax on 100% of their profit. As a sole proprietor, the only benefit received is the potential dollar for dollar adjustments for each business expense deducted. LLC’s and Sole Proprietors are taxed the same way (Federal, State and Self Employment tax on the full annual profit). As a C-Corporation, also known as a double-taxed entity, you must pay the corporate tax rate of roughly 35% as well as a dividend tax on whatever is drawn from the business by the shareholder. The only entity that has yielded any sort of tax benefit has been the Subchapter S-Corporation.
Again, your tax preparer will know best the benefits for your particular situation. The only differences from your current self-employment are: your income will go to your corporation; the IRS will require that you pay yourself a reasonable salary through your corporation, and you will pay the state of California an annual fee.
Let’s Talk About Retirement Accounts
With the S-Corp entity, an individual is also able to operate and fund all varieties of retirement accounts, including 401(k)s and IRA, and enjoy the further tax benefits of an S-Corporation. A very popular retirement account for the self-employed business investor/real estate investor is the Solo 401k or Self-Directed IRA account. These deferred retirement accounts are retirement vehicles that allow individuals to take control of their own retirement investments. What does that mean exactly? These accounts can invest in:
- Real estate rental investments
- Provide hard money loan services
- Acquire profitable companies
- Flip short-term investments
All while being sheltered within the tax-deferred retirement vehicle. This is a great way for self-employed individuals to build and control wealth within their own retirement accounts, free from the fragility of stock market investments. For passive real estate investors and producers in the entertainment industry without side investors, the LLC (Limited Liability Company) is an extremely valuable legal entity to keep your business assets separate from your individual assets. In the instance of multiple investment properties or multiple productions, LLCs will keep your business endeavors separate from each other.
The asset separation provided by the LLC structure is at its most valuable in times of tragedy and/or litigation. Should you become potentially liable for damages through a business endeavor or real estate asset, the LLC structure can limit your liability to only the assets contained within that entity.
As the new year ramps up, now is the time to speak to a tax consultant so they can project your tax liability for the current year, and make recommendations to reduce the amount of taxes that you would potentially owe.