Do you manage a one- or two-person business? You may want to re-evaluate the way you structure your business in 2019, as new tax rules change the incentives for very small companies. For instance, one of my small business owner clients recently asked me whether it made sense to reorganize a single member LLC into a solo S-Corporation because of the new 20% Qualified Business Income (QBI) Deduction. It’s a technical question, but it has broad implications. Today, I want to talk a little about these two business structures, how they’re affected by new tax laws and what you should consider in choosing the structure that’s right for you.
The differences between the two
The simplest form of business organization for very small companies is sole proprietorship, where you and your company are essentially the same entity. That works up to a point. But what if your business gets sued? You could lose your house, your personal savings, college accounts for your kids, even your car. If you want to shelter personal assets from legal liabilities, you have a choice between two types of business structures.
Single Member LLC
To avoid the unlimited liability of a sole proprietorship, you can turn to a single member LLC (Limited Liability Company). LLCs are straightforward to administer, and in most cases, you’ll still report income on a Schedule C. However, you gain some protection because your business is considered a separate entity.
In an LLC, you are only liable for damages up to the amount that you have invested in the business. However, you should make sure to keep your personal and business assets separate to prevent someone from “piercing the corporate veil.” Simply put, that means a creditor can sue for your personal assets because your business and personal assets are comingled and your LLC only serves as a shell for a separation that doesn’t actually exist.
You also have to take a few more steps to set up a LLC than you do for a sole proprietorship. You have to file articles or organization with your state, and you should have some sort of operation agreement that explains how the business will carry out its mission.
One last potential pitfall of the LLC is that you have to pay self-employment tax on all business profits because, for tax purpose, you and the business are one in the same. The self-employment tax rate is 15.3%, which consists of 12.4% in for social security and 2.9% for Medicare. You may remember these amounts that were withheld from your paystubs when you were an employee.
An S corporation separates you from your company completely, for both operational and tax purposes. The business is its own entity, and you as the owner are the sole shareholder and an employee. That division, however, comes with operational costs.
To create an S corporation, you have to file articles of incorporation with the state, appoint officers and create bylaws for the business. In addition, you have to adhere to corporate formalities including meetings of the board of directors and taking meeting minutes (even if you’re the only one in the meeting!). Lastly, you to the file a Form 1120s for the business and the business profit or loss will flow through to you personally on a Form K-1.
Many one- or two-person businesses find these requirements too time-consuming and expensive. Additionally, some states, like Illinois and New York, have additional taxes on and costs for S-Corps. But you can obtain significant tax savings if your business ends up making a substantial profit.
Determining the perfect salary
Before the TCJA, most of the talk around choosing an S-Corp vs. an LLC revolved around the self-employment tax savings mentioned above. For example, if you were an accountant that made $200,000 in net business income, and gave yourself a “reasonable salary” of $100,000, you’d save $15,300 in tax by having an S-Corp vs. an LLC. That’s a nice chunk of change.
The key issue here is what constitutes a reasonable salary. This issue has long been contested, as people tend to push reasonable limits in order to save in self-employment tax. Business owners have even more incentive now that the QBI deduction only allows a 20% deduction for profits from the business, not salary. (You can read my business owner cheat sheet on QBI here.)
The IRS determines reasonable-ness on a case-by-case basis but offers ten factors as guidelines. These include your role and duties in the company, your background and experience and amounts paid to others in similar-situated businesses. It’s a grey area, but experts have developed some rules of thumb — for example, the ideal salary is equal to one-third of business income up to the Social Security wage base, or, more recently, the “perfect salary” is 28.57% of your income.
While I love a good rule of thumb, small business owners who are making the decision between these two entities need to take extra precautions. If your business revenue comes mostly comes from your services, the IRS will likely see all of your business income as your salary. In other words, all of you solo accountants, advisors, etc. need to consider the fact that it may not be reasonable for you to have any dividend income at all. That fact defeats the purpose of having a more costly and burdensome S-Corp.
How to choose
These regulations are somewhat murky, and by now, you may be wondering if there’s any way to arrive at the right decision about business structure. My hope is to equip you with enough knowledge and tools to have an effective conversation with your tax or financial advisor. In that discussion take into consideration the following questions:
- What type of business do you have? Service businesses affect both the reasonable salary requirement and the ability to take the QBI deduction.
- How much of the income is derived from your work? Check out the IRS ten-factor reasonable salary test.
- Are you able to follow corporate formalities? You can hire someone to help with this.
- How much of your net business income is above or below the social security wage base ($132,900 for 2019)? The more above the wage base, the more appealing the 20% QBI deduction.
- Which retirement vehicles are you using? A single-member LLC, allows you to save faster with a Solo 401k.
Also, keep in mind that you don’t have to choose right away. As a single member LLC, you can elect to be taxed as an S-Corp, as long as the election is made no more than two months and 15 days after the beginning of the tax year you want the election to go into effect. You make the election on form 2553. You can also withdrawal that election by writing a letter to the IRS regarding your intentions.
One final word of caution: do not make these decisions in a vacuum. The savings in self-employment tax and QBI deduction will have to be balanced against one another. Additionally, a change in entity type can have long-lasting implications. We don’t know if the QBI deduction will be around after 2025. So talk to your tax and financial advisor to see how these provisions will affect you.