Many business owners launch their companies from the front lines — as an employee. And it’s not uncommon for owners to stay in that role, working with their staff members to grow the business and guide its strategic direction. Come tax time, however, owner-employees face a variety of distinctive tax-planning challenges.
Partnerships and LLCs
If you’re a partner in a partnership or a member of a limited liability company (LLC) that has elected to be disregarded or treated as a partnership, the entity’s income (and deductions) flow through to you. Trade or business income that flows through to you for income tax purposes likely will be subject to self-employment taxes — even if the income isn’t actually distributed to you.
You’ll also need to assess whether the additional 0.9% Medicare tax on earned income or the 3.8% net investment income tax (NIIT) will apply. Doing so will involve complex determinations.
For S corporations, even though the entity’s income flows through to you for income tax purposes, only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. To reduce these taxes, you may want to keep your salary relatively — but not unreasonably — low and increase your distributions of company income (which generally isn’t taxed at the corporate level or subject to employment taxes). The 3.8% NIIT may also apply.
In the case of C corporations, the entity’s income is taxed at the corporate level and only income you receive as salary is subject to employment taxes, and, if applicable, the 0.9% Medicare tax. Nevertheless, if the overall tax paid by both the corporation and you would be less, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level, are taxed at the shareholder level and could be subject to the 3.8% NIIT).
Tread carefully, however. The IRS remains always on the lookout for misclassification of corporate payments to shareholder-employees. The penalties and additional tax liability can be costly.
If you’re self-employed (such as a sole proprietor, partner or LLC member treated as either of them), your business earnings are subject to self-employment taxes. This means your employment tax liability typically doubles, because you must pay both the employee and employer portions of these taxes. The employer portion of self-employment taxes paid (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above the line.
As a self-employed taxpayer, you may benefit from other above-the-line deductions as well. You can deduct 100% of health insurance costs for yourself, your spouse and your dependents, up to your net income from the business. You also can deduct contributions to a retirement plan.
Above-the-line deductions are particularly valuable because they reduce your adjusted gross income and modified adjusted gross income, which are the triggers for certain additional taxes and phase outs of many tax breaks.
Owning and working for your own company can be incredibly fulfilling. But, tax planning is extra important when you take on this role. Please call us for help identifying the ideal strategies for your situation.