How you get money out of your company can make a huge difference. I meet people at the events I speak at, and they often proudly tell me that they already have an LLC set up. I ask them what they do, and then I ask them how their LLC is taxed. In well over a third of the cases, the person has no clue how their LLC is taxed. If the IRS is going to be taking a fourth or a third of everything you work so hard to earn, don’t you think it would be a good idea to know how they were making their claim on your work?
How your company is taxed could have a huge effect on how much money you end up with in your pocket. How do you get the most money out of your company? It depends on how you put the money into your company. Do you make the money in your company selling goods or services? Does your company make its money on rents or other “passive” or “unearned” income sources? Note that the IRS has its own ideas about classifying income. For example, if you are flipping real estate, you might think it is passive income, but the IRS could classify it as earned income.
Assuming your company is selling goods or services, you will probably want to be taxed under Subchapter S of the IRS Code. That means you will have a corporation or an LLC and have the entity taxed under Subchapter S. This will give you the opportunity to take a “reasonable salary” out of the company and then take the rest of the “profit” out as a distribution.
On the other hand, under Chapter C of the IRS Code there are only two ways you can take money out of the company. (Note that you could have either a corporation or LLC and choose to have the company taxed under Chapter C of the IRS Code.) Under Chapter C you can take money out as a wage. The wage earnings are subject to all of what I call the “social taxes.” (Social Security, FICA, FUTA, unemployment, etc.) The other way you can take money out of a Chapter C entity is to pay a dividend.
BUT, the dividend is subject to a double tax. A Chapter C entity pays its own tax on all of its profits. After the company has paid its tax, with its after tax money, the company can pay a dividend. When you get the dividend, that’s income to you. You have to pay tax on the dividend money you get. Thus, the double tax, once at the company level and then once at your level.
However, a distribution from a Subchapter S entity is not double taxed, and it is not considered earned income, so it is not subject to all of the social taxes. Can you see that if you can classify money coming out of a Subchapter S entity as a distribution, it will save a chunk of money? Actually, today it will save pretty close to 16% that would be lost in the social taxes. The government doesn’t want to lose its 16%, so they are really strict on making sure there is a reasonable salary paid out before the company declares a distribution.
A reasonable salary is the average salary in your location for the services rendered. Look on one of the job search websites for the wage for the job description in the location. Make a copy of the information you find and put the copy in with your taxes that year. That way if the IRS ever audits, you have the evidence to show how you came up with the “reasonable salary.”
If you know the income that will be earned is in fact passive or unearned income, such as rents, royalties, interest, etc., then you won’t use a Subchapter S tax structure. Of course, it would not be wise to use a Chapter C structure, because suddenly your passive income is trapped in the C taxed entity and the only way you can get it out is a wage subject to social taxes or a dividend subject to double taxation.
Passive income would warrant use of a sole proprietorship (Schedule C attached to your 1040 IRS form) or a partnership entity. For liability purposes, you would want an LLC taxed under the partnership rules or the individual sole proprietorship rules (disregarded entity rules).
The real gold mine in a small business is the tax deductions. Businesses have deduction possibilities that individuals simply don’t have. How you utilize the deduction options makes a huge impact on your taxes. Pointing out these deductions and showing you how to take advantage of them is the purpose of my mini course, Advanced Tax Tactics. There are lots of things you can do that your accountant dude has never mentioned. Our goal is to lower your tax bill by at least 20%.