Starting your own business is an exciting proposition: you’re the boss, and you get to do things your way. There are also many tax advantages to running a company. Entertainment expenses, for example, are generally tax-deductible at 50% of the cost. So if you take a potential client out for a meal, you can probably deduct 50% of the bill (which means that you aren’t taxed on that money).
There is, however, a pretty big tax hit that you take as a business owner: self-employment tax. Any income you make while self-employed—which includes income you make from your business—is taxed at a hefty 15.3%. This is in addition to regular income taxes.
LLCs vs. S-Corporations
Is there any way around this tax? Possibly. For small businesses, I generally recommend creating a Limited Liability Company (“LLC”). LLCs do a number of things for your business, but the big benefit is the liability shield. So long as you operate in a way that keeps you and the LLC distinct, your personal assets will not be at risk. An S-Corporation is another viable option for small businesses, but S-Corporations tend to require more formalities (e.g. annual meetings and minute books) than LLCs. S-Corporations do, however, have a potential tax benefit. In an S-Corporation, you may pay yourself a “reasonable” salary, and any excess funds can be distributed to you as dividends. Dividends are not subject to the 15.3% self-employment tax.
Imagine that your business makes $80,000. Without an S-Corporation, you pay $12,240 in self-employment tax. With an S-Corporation, you pay yourself $50,000 and take $30,000 as dividends. You just reduced your tax liability by $4,590! But wait. I said, “I generally recommend creating an LLC.” Why not an S-Corporation? Because you can have the best of both worlds. The IRS allows your LLC to elect to be taxed as an S-Corporation (by, among other things, filling out and submitting IRS Form 2553). Then, you have less formalities as an LLC, but you also have the ability to avoid self-employment tax.
You and John Edwards
If you’re afraid that something like this isn’t legal, just look at what John Edwards did from 1995 to 1999. In 1997 alone, Edwards made more than $26 million as an attorney (I’m apparently practicing the wrong kind of law). Yet he paid himself $360,000 in salary and took the rest as distributions. Over those years, Edwards saved approximately $600,000 in taxes! His tax returns were in the public eye in 2004, and no one—most importantly, not even the IRS—batted an eye at the legality of what he had done.
Use me to help you become the next John Edwards. Well, perhaps you’d prefer to use me to help you make as much money as John Edwards. Either way, I’m here and waiting for your call (574.514.3566).