A Guide to Legal
Entity Optimization

Strategy: S-Corporation

S Corporations are not taxed at the corporation level. Instead, they pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes.
Shareholders of S Corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S Corporations to avoid double taxation on the corporate income.

One major benefit of an S Corporation is that not all earnings may be subject to self-employment tax. An S Corporation shareholder is an owner-employee of the business. This means that the net profit from the business is a blend of self-employment income and a return of capital from the shareholder’s investment in the business.

The self-employment component is paid out as wages and is subject to self-employment tax. The return on the investment is paid out as a distribution, and is not subject to self-employment tax.

To prevent 100% of the earnings from being treated as distributions (and not paying self-employment tax), S Corporation shareholders are required to take “reasonable compensation.” Amounts taken as reasonable compensation are treated as wages, and the shareholder and corporation will pay FICA and Medicare taxes on those wages.

Since only a portion of net profit is subject to self-employment taxes, business owners can see significant savings on self-employment taxes. These are not one-time savings, but are available as long as the S Corporation is in business.

All net profit, whether distribution or wages (reasonable compensation) is still subject to income tax.

Sources

Internal Revenue Code sections and related regulations include IRC Sections 1361-1363.

S-Corporation Requirements

The client has elected to incorporate or become an LLC that may be taxed as an S Corporation. The client has also filed Form 2553 (Election by a Small Business Corporation) with the IRS.

In order to be eligible for a S Corporation status, the business must be a domestic corporation, have only allowable shareholders including individuals, certain trusts and estates and have no more than 100 shareholders. In addition, the S Corporation can have only one class of stock and cannot fall into an ineligible category such as certain financial institutions, insurance companies, and domestic international sales corporations.

Strategy: C-Corporation

In a C Corporation, the company’s earnings are taxed at the C Corporation rate, rather than at the individual’s tax rate. The owner is not required to take profits out of the C Corporation and they can be retained within the corporation. This allows the total tax to stay at the lower C Corporation rate. However, if the individual decides to take out profits from the company, the individual will also be taxed on those dividends in addition to the income taxes on the earnings at the C Corporation level (double taxation).

In a business where substantial profits are being reinvested into the business rather than being distributed to owners, a C Corporation structure may be more beneficial. Under TCJA, corporate income tax rates are a flat 21% where individual tax rates on pass-through income are likely much higher.

The tax savings calculation will be the difference between the individual owner tax rates and the corporate tax rate.

C Corporations can be a good way to provide valuable fringe benefits to the employees of the corporation, including the shareholders.

A C Corporation is a separate legal entity and does provide personal liability protection to the shareholder for the debts of the business. However, as a separate entity, an additional income tax return must be filed. There are also additional paperwork requirements for the C Corporation, such preparing the Articles of Incorporation and recording meeting minutes.

Sources

Internal Revenue Code sections and related regulations include 26 U.S. Code § 11; IRC Section 13001(a).

C-Corporation Requirements

The client has elected to incorporate or be taxed as a C Corporation.

Strategy: Partnership

A partnership is an entity owned by two or more people for a trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.
A partnership does not pay tax at the partnership level, but instead passes through the income, deductions, gains, losses, etc., from its operations to its partners. Each partner reports their share of the partnership’s income or loss on their personal tax return.

Partners are not employees, and do not receive a W-2 from the partnership.

Partnerships are extremely flexible, with the terms of the partnership set forth in the partnership agreement. Included in the partnership agreement will be the per partner allocation of income and losses.

A partner can be either a general partner or a limited partner. The general partner is involved in the day-to-day operations of the business. 
Each partnership must have at least one 
general partner.

General partners are subject to both income tax and self-employment tax based on their percentage of income from the partnership.

General partners may also be personally liable for the debt of the partnership and their 
other partners.

Limited partners are investors in the partnership and are not subject to self-employment tax, but are subject to income tax on the net profit of the business. Limited partners typically are not liable for 
the debts of the business. Some partnership agreements may include guaranteed payments to certain partners based on services provided or capital invested. Guaranteed payments are subject to self-employment tax to the partner that receives them, even for limited partners.

Sources

Internal Revenue Code sections and related regulations include IRC Publication 541

S-Corporation Requirements

A partnership agreement and other legal documents are prepared to form the partnership.