Overview of Business Entity Taxation
I pay too much in taxes! 😐
Could an S-Corp help? 🤞
If you’re a therapist in private practice, and wondering how your LLC or Professional Corporation can help you better manage your income taxes, then today’s post is for you. We’re going to discuss all the ins and outs of business entities taxation. Yes, this might sound a bit dry - but having this knowledge is essential for you to decide whether the S-Corp election is the right move for you. And an S-Corp can save you a lot in taxes - if you understand the mechanics and implement it the right way.
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Before we dive in, I want to remind you that this post doesn't contain specific recommendations (or tax advice) for you to implement. These are general guidelines and ideas to think through on your own or - even better - in concert with your tax preparer, business attorney and financial planner.
I am a financial planner and not an attorney or a CPA. Only properly licensed attorneys are authorized to provide you legal advice. Only your CPA is the expert on calculating the specifics of your tax situation. Today's post will provide a general overview of how the tax system works.
And of course I know nothing of your specific situation. As always, if you require specific guidance for your situation, please reach out to a professional! I am always happy to have a complimentary meeting with you.
If any of what I cover below seems confusing, be sure and check out these related posts. You might almost think of them as prerequisites for today's content.
- Understanding your Practice Profit & Loss Statement
- Business Entities 101 for Therapists
- Understanding Taxes & Your Private Practice
And remember to take it easy on yourself as you work through this content. This stuff is confusing and complicated. So many people - including some financial professionals - don't understand these details. I see so many mistakes when it comes to S-Corps and managing taxes. This is something you don't want to get wrong - it can really come back to bite you. So your efforts here will be well worth it!
Earnings before Taxes
As we go through this discussion, it's important to remember that for most taxes you do NOT pay taxes on all money coming into your practice. Rather, you owe taxes on the money that's left over after you deduct expenses. That line item on your P&L is typically called Earnings before Taxes, or Taxable Income. Confused? That's ok - go back and check out my post on understanding your practice P&L.
Three Different Types of Taxes
Second important note on taxes: there are three different kinds of tax that will impact your take-home (e.g. after-tax) earnings from your practice. Those three are: income tax, earned income tax (aka FICA tax) and payroll taxes. As illustrated below, these different types of tax are assessed on different types of income from your practice.
The smallest circle represents salary paid through payroll. Payroll is assessed all three types of tax: payroll tax, FICA tax and income tax. The middle sized circle represents eared income. Earned income is what you earn for working a job, or from owning your own business. Payroll is one type of earned income, which is why the payroll circle is inside the earned income circle Non-payroll earned income avoids payroll taxes but is hit with both FICA and income tax. Finally, we have other forms of income which are not earned income - and that income is "only" hit with income tax.
These different categories might seem confusing. Because they are. Go back and review the Understanding Taxes & Your Private Practice post if these distinctions feel a little shaky. Because while this is confusing, it is also the reason the S-Corp election can save you money on your taxes.
Default Taxation: Sole Props & Partnerships
Let's first consider how Sole Props and Partnerships are taxed. Sole props and partnerships are the business entities which automatically come into existence when you start doing business by yourself (in the case of a sole prop) OR when you start doing business with partners (in the case of a partnership). Because these types of business entities exist by default, I consider the way they are taxed as the default method of taxation. In other words, if you don't take any special actions, this default taxation is what will apply to you.
Looking for more great resources to help you navigate your financial life? Check out my free Guide to Financial Planning for Therapists. Click here to access!
As a sole prop or partnership, all of your "Earnings before Taxes" are hit with income tax and FICA tax. But you won't pay any payroll taxes because your earnings don't come through a paycheck. Instead of payroll, you take a distribution of earnings, or what is sometimes known as an owner's draw.
I will also caution you that if you’re operating as a partnership the taxes can get very confusing very quickly. You have to allocate earnings and tax among the different partners and perform other complex calculations. I highly encourage you to work with a qualified CPA or tax accountant to help you make sure you’re handling partnership taxation correctly.
One last point: both sole props and partnerships are what are called “pass-through” entities for tax purposes. What the heck is that? Pass through means that these business entities don’t pay income tax directly. Rather, the taxable income they generate is passed through to the owners - which is you. That means that the business’s earnings are reported on your personal income tax return. You don’t get a choice here: the moment your business has income, you must report that income on your tax return in the same year.
Fancy Taxation: Corporations
Corporations are the other side of the tax coin: they are more complex! But in that complexity tax savings can be found! To help explain how that tax savings works, let's look back at the standard Profit & Loss statement.
When it comes to a Corporation's P&L, there is one small - but critically important - change from the P&L of a sole prop or partnership. As the owner, you also draw a salary from the business and that salary will be paid through the running of payroll. That means that the cost of your owner's salary is included in the business expenses. Because your payroll is included, your business expenses are higher. And because expenses are higher, the corporation's earnings before taxes are lower. I know this might be starting to get a bit confusing, but hang in there. 😃
When your business entity is a corporation, your owner's compensation comes in two parts: your salary that is paid to you through payroll PLUS the distribution of the net earnings. The total compensation your receive from your business is unchanged - but it's split into two different parts. And that's where the tax magic happens, because those two different parts are taxed differently.
Your salary through payroll continues to be assessed both income tax and FICA tax. And because it's coming through payroll it now gets hit with an additional tax: payroll taxes.
That additional payroll tax is a bummer, but there is an upside. The profit distributions you take from the business avoid FICA tax - they only get hit with income tax. And payroll tax if tiny compared with FICA tax, which means you can pay a lot less in taxes.
I know this part is a lot to process, so let's review how these different taxes are being applied in the same table format we looked at for the sole prop and partnership.
Income tax will be assessed on both your payroll salary and the business earnings before taxes. But when it comes to FICA tax and payroll tax - only your salary which is paid through payroll gets hit those taxes. Unlike the sole prop and partnership tax picture where all of your business earnings before taxes got hit with FICA tax, here only your salary portion of compensation gets hit with FICA.
Avoiding FICA on the profit distribution from your business can be a big tax benefit. The "price" you pay to achieve those FICA tax savings are the payroll taxes that your salary gets hit with. Remember in the world of sole prop and partnerships, the owner's earnings are never assessed payroll taxes - because owners aren't paid through payroll in those types of business entities.
What about a LLC's? How are LLC's taxed?
You might be wondering why I’ve left LLCs out of this discussion so far. especially because LLCs - or Limited Liability Companies - are a very popular entity choice.
So how are LLCs taxed? LLC taxation is entirely choose your own adventure. LLCs are a relatively new invention in the world of business entities, so when they came on the scene the taxing authorities (arguably for the first time in history) tried to keep things simple. They decided to tax LLCs as if they were one of the other business entities. Which one of the other business entities? Well, any of them as it turns out. Let me explain.
If you run your practice through an LLC and you are the only owner of that LLC, the IRS will treat the LLC as a “disregarded entity” for tax purposes. What that means is that they tax you as if you were a sole prop. This is an important point: the default taxation of LLC's is the same taxation as sole props. That means there is literally no tax benefit to forming an LLC. This is something a lot of people misunderstand. If all you do is form an LLC, your tax picture will be entirely unchanged - except you probably have to pay some new taxes and fees to keep your LLC in good standing.
Similarly, if you are operating an LLC with more than one owner, the default tax treatment is partnership taxation. Which makes sense, because remember a partnership is analogous to a sole prop, the only difference being you're not working by yourself, you’re working together with partners. Here again the LLC offers you no tax advantage relative to a standard partnership.
LLC's May Elect to be Taxed like a Corporation or an S-Corporation
What we've covered so far is is just the default tax treatment. LLCs can elect to be taxed as a corporation. But you do have to opt-in to this treatment by letting the IRS know. The process isn’t overly complicated, but you want to make sure and get it right, making this a good time to work with a tax professional.
Once you've let the IRS know that you want your LLC to be taxed like a corporation, you can take the second step and make the S-Corp election. The S-Corp election allows you to take advantage of the tax benefit of splitting your owner's compensation into salary and profit distributions AND maintains the pass-through tax benefits.
If your head wasn't spinning before we introduced S-Corp taxation here, I don't blame you. The S-Corp election is complicated and comes with quite a few downsides. Which is why in a future video I will cover what you need to know when considering this S-Corp Election. The S-Corp election is not something you should take lightly - I see so many mistakes and regret when it comes to S-Corps. Be sure and stay tuned for that next post on S-Corps.
That's a Wrap 🎬
Alright, I hope you found this post helpful! This was a LOT of information. So, let me know if that avalanche of information was helpful! What made sense, and what points are still confusing? What else would you like to hear about that would be helpful? Give me a shout and lemme know!
And if this all feels a bit much, give me a shout. I work one-on-one with therapists from all over the country helping them address issues just like the ones we talked about today! There are a bunch of different ways to work with me which I describe on my services page.
Turning Point is a registered investment advisor in the state of California. Please visit turningpointhq.com for important information and additional disclosures. This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes financial, legal or tax advice; a recommendation for purchase or sale of any security; or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Read the full Disclaimer here.