Although ENDEAVORLEGAL does not maintain a full-service taxation practice, our lawyers regularly provide counsel to our clients regarding tax planning and compliance for businesses and individual clients. Our attorneys work with clients and their accountants to devise creative, practical solutions that take into account tax and non-tax considerations, including business objectives and accounting rules. One important area of our business practice are the taxation aspects of choice of entity considerations and implementing equity compensation arrangements (discussed below).
The Federal taxation implications of running a business are an important factor to consider when starting a new venture. Proper tax planning provides an entrepreneur with a number of tax benefits and can save many tax dollars over the course of the life cycle of a business.
Choice of Entity: Taxation Considerations
The paragraphs below describe certain Federal taxation issues an entrepreneur should consider when determining which type of entity is best suited for his business objectives. Please note that this information is not a comprehensive description of “start-up” taxation considerations but rather an overview. Persons in the planning phase of starting a new venture should consult a Certified Public Accountant or other tax advisor in addition to business attorneys prior to making any “choice of entity” decisions.
Corporation taxed under Subchapter C of the Internal Revenue Code
Wages Paid to Employees, including Owners. Corporations are permitted a deduction for wages paid so long as wages are reasonable. There is a risk that the Internal Revenue Service may reclassify unreasonable wages as dividends. Owners are subject to taxation on wages received at ordinary income rates. Owners pay no self-employment tax; the employer corporation and employee each pay a portion of employment taxes (Social Security and Medicare). Health insurance premiums are deductible by the employer corporation and excluded from the owner’s income.
Dividends Paid to Owners. Corporations are not permitted deductions for dividends paid to shareholders. All income is taxed at the entity level prior to distribution of dividends to shareholders. Owners are subject to taxation on dividends received at ordinary income rates; thus “two-tiered” or “double taxation.” Dividends are not subject to employment taxes.
Corporation taxed under Subchapter S of the Internal Revenue Code
Wages Paid to Employees, including Owners. The corporation is not taxed, except for certain states’ taxes. Wages paid to owners are deductible in determining income passed through to owners. Owners are subject to taxation on wages received at ordinary income rates. Owners pay no self-employment tax; the employer corporation and employee each pay a portion of employment taxes (Social Security and Medicare). Health insurance premiums are one hundred percent (100%) deductible by owners of greater than two percent (2%) of the corporation’s stock.
Distributive Share Allocated to Owners. There is no taxation at the entity level, except for certain states’ taxes). Owners are subject to taxation on their distributive share at ordinary income tax rates whether or not profits are actually distributed. Owners are not subject to self-employment tax on the distributive share. Although the distributive share is not subject to employment taxes, there is a risk that if no salaries are paid to owners who provide services to the corporation, distributions will likely to be re-characterized as wages in order to assess employment taxes. Furthermore, if health insurance premiums are included in owner’s distributive share it may support the conclusion that the owner is also an employee for employment tax purposes.
Partnerships (all Types) and Limited Liability Company (LLC)
In general, partners of a partnership and members of a LLC receive similar tax treatment when they receive wages and when they are allocated their distributive share of net profits (although guaranteed wages are treated differently in terms of adjustments to capital accounts). There is no taxation at the entity level, except for the possibility of certain states’ taxes. Owners are subject to taxation on their distributive share at ordinary income tax rates whether or not net profits are actually distributed. Owners pay one hundred percent (100%) of Social Security and Medicare taxes; they are taxed as self-employed individuals. Health insurance premiums are tax deductible.