Transcription
Your legal business entity structure is going to play a huge role in the type of taxes you pay and ultimately how much you have to pay. That's why one of the first things we want to evaluate when we're trying to optimize our taxes is going to be looking at your legal business entity. So, this lesson is going to be helpful whether you are starting a new business or you have an existing business and you're wondering whether or not you have the right structure in place.
So, what I want to do is quickly cover why choosing the right entity is important, share an overview of the four types of entities and subtypes and simplify which one may be better for you based on your business and your goals. Let's go ahead and jump in with number one. What is a business entity or legal structure? The easiest way to describe a business entity is that it is a structure in which you will conduct and engage in business activities. Now, if you are not proactive about selecting your own business entity, then by default, you usually will become what is called a sole proprietor, which isn't necessarily a bad thing. And I want you to know that if you have already become or selected a business entity that you can always switch to another legal entity structure later on or elect to be taxed differently, which we'll get into a little bit more later.
Now, a big misconception for many people is they think that you need to have a particular business structure in order to write off any business expenses. But this is not the case. Okay? You get the same tax write-offs, the same tax deductions as you would for a sole proprietorship, LLC, or SC corporation. Okay? As long as you identify as a self-employed business owner, then guess what? You can write off almost anything.
Now, generally speaking, to set up a business entity structure, you would simply register your business with your state where you would make sure the business name is available in that state, list out all the partners or members associated with the business, create an operations agreement stating how the business will be managed, and choose your legal entity structure. Then you'd also need to list a registered agent who would receive mail or correspondence on behalf of the business and then pay a small registration fee and you'd be set up.
Okay, now that you understand what a business entity is, let's go ahead and talk about number two, why choosing the right entity is important. So, there are three big factors that you want to be taking a look at when you're deciding how to choose your structure for your company. You have the legal protections offered by the entity, the tax treatment and potential outcomes of the entity and the level of government regulation associated with the business entity. So you have this sort of puzzle of options that you want to be thinking through because if you select the wrong entity then you may end up okay putting your personal assets at risk, paying more in taxes than you actually need to or going through some unnecessary government regulations and requirements. So you want to make sure you're choosing wisely so that you have the best possible outcomes.
All right, let's go ahead and move on to number three and break down the four types of business entities. You can sum up business entities into four types. Okay, you have sole proprietorships, partnerships, corporations, and LLC's. And then you have subtypes. So, let's go through each one.
Starting with number one, a sole proprietorship. So, simply put, a sole proprietorship is the simplest business entity of them all. In fact, under law, if you launch a new business and you are the sole owner, you will automatically become a sole proprietor. This means that you don't need to go to your state and register or file any paperwork. Although some states will require you to have maybe a local business license or a permit to offer specific goods and services. Typically, people who automatically become sole proprietors are freelancers, consultants, drivers, independent contractors, or other professionals who are offering services without registering their business entity. Which is why it is the most common business structure of them all. Because some people set up these side hustles or gigs without realizing they are starting a business and so by default they become a sole proprietorship.
Now there are several benefits of being a sole proprietor. Okay. One, it is easy to set up. So you don't have to register with the state. Plus there is no paperwork or ongoing requirements to be filed and you still get to take advantage of all the business tax deductions that you qualify for. Plus, filing your taxes are less complicated and generally less expensive.
Now, the major, and I mean the major drawback of a sole proprietorship is that you do not have any legal limited liability protections because as a sole proprietorship, you are personally responsible for all the debts and all the liabilities of your business. So if someone sues your business, then they can try to claim your personal assets like your car, your home, or even your personal bank accounts. Okay, so that's a big one. Another con of a sole proprietorship is that it is harder to build business credit since there is no legal separation between you and the business. Thus, it can be harder to get a full financial picture of your personal side and your business side. And for those reasons, many people eventually convert their business into what is called a single member LLC or a corporation.
But first, let's go ahead and talk about number two, partnerships. So, when it comes to a partnership, we have to talk about two different types. There is a general partnership, which pretty much is identical to a sole proprietorship with the main difference being instead of there only being one owner, there's going to be two or more owners in the business. And because of this, you're going to be required to file what is called a 1065 partnership return. However, there is an exception where if you are partnering with your spouse, then you may be able to file what is called a qualified joint venture, which allows you to file your partnership on one 1040 tax return.
The next type of partnership is known as a limited partnership or LP. And unlike the other two and the ones that we're going to talk about going forward, this is an entity that you must register with your state. So in a limited partner, you have two types of partners, right? You have a general partner and then you have a limited partner. So the general partner acts as the manager of the business and they are the ones who generally operate the day-to-day and they assume personal liability of the company. whereas the limited partner acts more of a like a passive investor. And and so in this type of partnership, the general partner is still held personally liable for the company, whereas the limited partner does have limited liability protection from their personal assets. So if you are working with an investor, sometimes they prefer that you have this type of structure in place so that the general partner has a little bit more at stake.
Now, both sle proprietors and partnerships have the option to structure their operations inside of number three, the limited liability company or LLC. Cuz you can have a single member LLC where you are the sole owner or a multimember LLC where you partner with other people which can be a managing member or a limited member. And this entity is very popular because you and all of your partners receive what is called limited liability protection which legally safeguards your business from being personally responsible for the company's debts or liabilities. This means that if the business faces financial trouble, lawsuits or debts, the owner's personal assets, like again their home, their cars, their bank accounts are not at risk, which of course is a major pro. But, and I've seen this happen before, if you personally guarantee any loans or contracts with your personal name on it, then you can still be held liable even with an LLC. So, you definitely want to keep that in mind. And when you're executing contracts, make sure you're doing it under your LLC's information.
Now, another big benefit of an LLC is that you have flexibility in the way that you want to be taxed. You can be taxed as a sole proprietor, an SC corporation, or even a Ccorporation, which is something that we're going to look at a little bit more in depth in our upcoming lesson. But it makes the LLC extremely flexible, and there are hardly any cons outside of the fact that you do have to register the business with the state and you do have to pay some extra annual fees.
Let's move on and talk about the fourth type of entity, which is number four, corporations. Real quick, if you don't know who I am, hey there. I'm Sean, a licensed tax professional. And before we move on, I wanted to tell you about an AI powered software that I personally use to run all my businesses that I recommend to other small businesses and the sponsor of today's video, HighLevel. Highlevel is basically everything you need to run your business in one platform. There are sales pipelines, marketing tools, website builders, workflow automations, and so much more. And recently, they've added new AI features that are absolutely insane. I'm talking about voice AI agents that can literally answer your phone and have full conversations with your prospects and even book them into your calendar. There's also AI chat agents that can respond to every single message across all your platforms instantly. It's like having an AI employee that never sleeps, never takes a break, and never makes a mistake. And when you use the link down in the description below, you can get access to a free trial. And by using my link, you also get an exclusive free 1-hour onboarding call with a highlevel expert so you can go ahead and set up these AI systems immediately. And you'll also get access to my new AI business blueprint course breaking down how you can use this software to start and grow your business. So go ahead and click the first link down in the description below because you're going to want to see this AI in action.
All right, now let's get back into the next section in this video. And there are two subtypes. You have the Ccorporation and the S corporation. When it comes to the Ccorporation, I think this is probably the most advanced business entity that exists because it is totally separate from individuals legal and tax entities. You see, the business entities that we talked about so far are pass through entities, which means the business profits are taxed at individual tax rates. However, what makes a Ccorporation unique is that it currently has a flat 21% tax rate on any business profits it makes. But here's the kicker. Business profits must remain in a Ccorporation. And so if the owner or shareholder would like to pay themselves, then they either need to take a salary or take a distribution as a dividend. And when you do this, you will be taxed again at your individual tax rate, which is known as double taxation. Plus, Ccorporations have more administrative requirements and cost the most money to maintain. So unless you are comfortable with not taking any business profits and reinvesting almost everything back into your business, then we generally recommend you stay away from this type of structure and instead look into what is called an S corporation.
Now some people argue whether or not an S corporation is a business entity or simply a tax election, but regardless of where you stand, here is how an escorp works. Okay, it is a very flexible business structure with the major pros being owners or shareholders have personal limited liability protection. Thus, they are able to protect their personal assets. There is no double taxation or corporate tax rate to pay and there is no self-employment taxes applied to any owner distributions or shareholder distributions. On the flip side, the major cons are you are required to pay yourself a reasonable salary. And although you can issue stock, there are limits to what type of stock you can issue and how many you can issue. And you still need to comply with government requirements such as creating bylaws and holding and recording shareholder meetings.
Now, I'll have an entire section where I break down the escorp strategy. So right now what I want to do is move on and discuss some best practices on number four. How to choose the right business structure. Now there are two things I want to mention here. First, you should know the vision and plan for your business operations more than anyone else. So I implore you to think carefully about the pros and the cons of various business entities. Second, this is my personal list in tiers that I use to help guide people towards making their own decision, but this by no means are hard rules or requirements. Okay, so in my tier number one, I have sole proprietorships and general partnerships. So, I think this is great for people who are not worried about having limited liability protection and want to get going quickly without having to worry about filing additional paperwork or annual registration fees. and you don't forecast having more than about $250,000 in income. For example, if you are self-employed and you're working underneath a larger corporation or a company as an independent contractor, they may already offer additional limited liability protection as a company or require insurance policies or have airtight agreements. In fact, a lot of our clients who are physicians have this extra layer of protection.
Okay, moving on. In tier two, I have limited liability companies or LLC's, which are great for entrepreneurs who are stepping out on their own and now they need some limited liability protection for their personal assets. And I like to recommend this as a starting place because this is an entity that you can grow with as you start to make more income and you can elect to be taxed differently later on. Also, this is a great place to start building up some business credit. And so if you're in the need of raising some capital or funding a small business project, you'll have some business credit to do so.
And then in tier three, I have S corporations because after you started to gain some initial traction and your business is growing, then you may need a couple things, right? For example, you may have a product or a service that has strong demand and you're struggling to keep up. So maybe you need some additional growth capital from other shareholders. Well, this S corporation is going to allow you to raise money. Or maybe your business profits are good and you are making enough money to put yourself on payroll to avoid some self-employment taxes. In other words, I think S corporations are great for companies that are growing and can handle a little bit more administration.
And then finally in tier four, you guessed it, I have Ccorporations, which are great for companies that project having significant amounts of revenues or raising a significant amount of capital from investors or shareholders, and they're willing to make aggressive investments back into their company while maintaining positive growth trajectories. So that's my take and what I generally recommend to our clients. Now, I think many people are going to fall in tier 2 with an LLC and then they have the ability to grow from there.
Coming up next, what I want to do is talk about the tax outcomes of some of these entities and what it means to be pass through versus having a corporate tax rate. Let's talk about what it means to be a pass through entity because this is something that often confuses many business owners. So, a pass through entity is a business structure where the company's profits and losses passes through to the owners on their personal tax return. The business itself does not pay any federal income taxes. Instead, the owners report the business profits, the business income on their personal tax returns and then they pay taxes at their personal income tax rates. Sle proprietorships, partnerships, both general and limited LLC's, both single member LLC's and multimember LLC's and S corporations are all pass through entities.
So, here's an example. Let's say John owns a marketing agency and he set up his business as a single member LLC. He's off to a great start and earns $200,000 in net profit for the year. Because his LLC is a pass through entity, that $200,000 flows directly to line 8 of his personal tax return on additional income from schedule 1. And because it flows here, he will pay taxes on his income on his business income plus any other income that he has. And he's going to pay that at his individual income tax rate, which would make his federal taxes due $34,077. But since John is self-employed, he would also need to pay some self-employment taxes, which would be a massive $28,26. And we'll talk about how John could cut his tax bill with an S corporation a little bit later. But for now, these amounts would bring his total tax liability to about $63,284.
Now, here's where a lot of people get confused. When you have a pass through entity, the bank balances do not matter. Some people are under the impression that if they leave all their profits in their business bank account and they never transfer it to their personal account that they don't have to pay any taxes. But that is not the case. Okay? You are taxed based on the profits that the business makes and passes through to your personal tax return regardless of any amounts that are in your bank accounts or any transfers that you do or do not make. So on your profit and loss statement, if you show that you made $300,000 in revenue and you had $100,000 in expenses, then your profit would be $200,000. And that is what is going to flow through to your personal tax return. Okay, I hope that makes sense.
Now, the only entity structure that is not considered to be a pass through entity currently is the Ccorporation, which as we have discussed, Ccorporations are taxed at a flat rate, which for 2025 is 21%. So, if you have a Ccorporation with $200,000 in profits, then your taxes owed would be $42,000. Now, you may be thinking, "Okay, so a Ccorporation is better because I only have to pay $42,000 instead of $63,000 from the earlier example, right?" Well, not exactly. Here's the catch. Okay, the business profits must remain on the books of a Ccorporation. And if you actually wanted to pay yourself or distribute the remaining profits, which in this case would be $158,000, then guess what? You're going to be taxed again. specifically paying a dividend tax. So, the total tax would look something like this. Your corporate taxes would be $42,000. Your dividend taxes would be $23,700, which is 15% time $158,000. So, your total taxes paid would be $65,700. So, in this example, you would actually pay more with a Ccorporation. And you should know that Ccorporations have the most administrative requirements and cost the most amount of money to maintain. Plus, there are a couple of ways that we can optimize our pass through entities which would reduce the taxes owed. So, let's get into that next.
All right, let's start optimizing. So, here's the deal. Most working age people are going to pay federal and state taxes on any income that they earn. Yes, you may qualify for deductions or credits that reduce your tax liability or even put you in a position to receive a tax refund, but ultimately you can't get around these taxes. But there are some taxes that you can get around. And the big nasty one that we like to focus on for most business owners is the self-employment tax. And it tends to hit a lot of new business owners or contractors unexpectedly because it's not something that you have to think about or pay for when you are a W2 employee. Because when you are a W2 employee, your FICA or your Social Security and Medicare taxes are withheld from your paycheck, which is roughly 7.5% of your income. Now, here's what you probably didn't know, okay? Your employer also had to pay roughly 7.5% of your income in FICA taxes as well. So in total, roughly 15.3% of your income is being paid to the government in employment taxes. Well, as a business owner, you don't have anyone withholding these taxes. And so you'll need to pay the full 15.3% which are called selfmployment taxes. And people who are subject to this tax are anyone who files a schedule C such as sole proprietorships or general partners, 1099 contractors, single member LLC, and managing members of partnership.
Now, I'm going to give you three ways that you can start to strategize and reduce this tax that can potentially save you thousands of dollars in tax payments over time. And to make this stick, I'm going to look at three scenarios. And in each scenario, we're going to say you earned $100,000 in business profits. Okay? And number one, you have an active member managed LLC. Well, in this case, regardless if you have a single member LLC owned by one person or you are a partnership LLC owned by multiple people, you are likely going to be subject to self-employment taxes. And if you are stuck or it just makes sense for you to remain as an LLC, then the only way that you can avoid this is by having a business loss or reducing your business income as close to zero as possible. Now, this is actually possible with a lot of the other strategies that I talk about like maximizing deductions or making strategic investments. And with those, if you don't completely eliminate the self-employment tax, you should see a significant decrease, right? But if that doesn't get you enough savings, then maybe you need to enjoy scenario number two, where you decide to have your LLC elect to be taxed as an SC corporation. Because when you elect for S corp status, then the taxable income is divided into two parts. Okay? you have a distribution and a salary because escortp shareholders can be both owners and employees where you pay yourself a W2 salary. So when you do this, you'll only pay social security and Medicare taxes on the salary portion instead of all your net profit. For example, let's say you have an S corporation with taxable income of $100,000 and you pay yourself $50,000 as a salary and you take a $50,000 distribution. Well, now you only need to pay 15.3% on the $50,000 salary, which is $7,650 as opposed to $15,300. And on the other $50,000 distribution, you won't have to pay any self-employment taxes as it is going to pass through on your personal tax return through a K1 and flow through the schedule E which are exempt from self-employment taxes. And so you pay no self-employment taxes on the $50,000 distribution. And so this is an easy way to potentially cut your self-employment taxes by half, if not more.
Now, because this tax strategy is so popular to use, I'm going to spend a couple of minutes sharing the requirements of an S corporation, how to elect to be taxed as an escorp, and what to expect next. So, let's first talk about the requirements of an S corporation. For starters, number one, to be eligible for escorp elections, your business must be incorporated in the United States. Number two, you must have less than 100 shareholders and those shareholders must be US citizens or resident aliens. Also, only individuals in the states can be shareholders. So, no other partnerships, corporations, or even LLC's can actually own shares of your SC corporation. Number three, you must only issue one class of stock. meaning all of shareholders have the same rights to profits and losses and no preferred stock is allowed. And side note, these restrictions actually make it difficult to buy or sell shares of an S corporation. Number four, and probably most importantly, shareholders that actively participate in the operations of the company must be paid what is called a reasonable salary, which in many cases means you, as the business owner, are now required to pay yourself as a W2 employee. And number five, of course, you must remain compliant by maintaining corporate formalities like holding shareholder meetings, recording those minutes, renewing registrations, and filing annual tax returns. And these requirements are important because you could lose your escorp status if you are not compliant and have to be exposed to repaying all those self-employment taxes that you avoided.
All right. Now, if all that sounds good to you, then let's move on and talk about how to set up an SC corporation step by step. Step one, of course, is to form an LLC or corporation if you haven't already. Step two, make sure you review the requirements, and this is something that you want to do. After that, step three is to file form 2553 with the IRS. Now, there are two ways to become an escorp. You can make a current year escortp tax election or you can do what is called a late escorp tax election which allows you to go back and become an escorp for the three previous tax years. To do a current year election, you must file form 2553 with the IRS within 75 days of the formation or the start of the tax year.
Let's go through and complete form 2553. Most people only need to complete part one. So, at the very top, you're going to put in your business information like the name, employer identification number, address, the date it was incorporated, which would be the date you registered the LLC, and the state of incorporation. On line D, check if you change your business name or address after applying for EIN. On line E, select the month, day, and year you want the election to be effective. If you are doing this in the current year, then you're going to likely put down January 1st, 2025. Although this date could be different if you are a Ccorporation and you're working through a different physical year. Now, on line F, once again, most people will select the calendar year unless you are a Ccorporation. Then, most people will skip line G. And then on line H, you would put your name and your title and phone number. Now, line I is for late elections, which we'll go back to in a second, but for now, let's go ahead and move on to the next page. And at the very top, you will see name and EIN. A lot of people miss this, but make sure you add your business name and EIN at the very top of the page. Then, in column J, you would put your personal name and your address. And in column K is where you want to add your signature and date. But the IRS wants this to be a wet ink signature. So you want to do this part last. And then in column L, you want to put the number of shares or your ownership percentage, which if you are the only owner would simply be 100%. And the date would be whatever date you put on line E above. Next, in column M, you're going to add your social security number. And then lastly in column N, most shareholders will have December 31st as their tax year's ending month and date. But again, that could vary if you have a Ccorporation with a different physical year, which is where part two and part three of this 2553 form comes in as well. Now, doing this for a Ccorporation is a bit out of scope for this video. So, we're going to ignore part two and three for now because these pages are actually not required to be completed to make an escorp election.
Now, once this form is complete, then you would simply print it out and go back to column K where you add in your signature and date. And from there, you have two options. You can mail it into the IRS, which is what I typically recommend, or you could fax it over. Now, exactly where you mail or fax the 2553 form to depends on the state that the business is registered in. You can find the addresses and numbers and the instructions for form 2553. And I'll also put them below. So, that's how it's done if you are within 75 days of formation or the current tax year and you want to make the election for the current year.
Now, if you want to make a past year or past year's election or after the 75day mark, then you would make a late S election. For this, there are two to three additional things you need to do. First, at the very top of the form, you want to write in file pursuant to Rev PROC 2013, which is the specific tax code that allows for late S elections. Next, you want to go back to line I. And for this, you have two options. You could either write in your statement for filing late, which could be as simple as something like, I wasn't aware of the requirement. Here's an example statement. The late election occurred due to a misunderstanding of the filing deadline requirements. As a new business, we were unaware that form 2553 needed to be filed within the first 75 days of the tax year. Once we became aware of this requirement, we immediately took corrective action and are now filing relief under revrock 2013-30. The corporation and its shareholders have consistently treated the entity as an S corporation for tax reporting purposes. Now the other option which I like to do to avoid any confusion is to write in column I C letter attached and then write a letter about making the late S election which I'll give you a sample 2553 form in a templated letter so that you can easily make it your own. From there the same thing applies. You can fax it or mail it in to the correct IRS department based on the state that your business is registered in and then you're done.
So here's what to expect next. So, the IRS typically processes form 2553 within 90 days of receiving it. And if you haven't received a response within that time frame, then you can contact the IRS to inquire about the application status. That being said, and you know this if you've ever tried to call the IRS, that it is not unusual for them to experience delays, especially around tax season. So, I tell my clients to expect at least six months. And if it happens sooner, then of course that's great news. Now, once the IRS reviews, then typically it is approved unless you filled out something incorrectly on the application, like maybe your EIN number was wrong, in which case the agency would send you a letter explaining why you're being rejected. So once you have received an approval letter, then you can immediately start to looking at paying yourself a reasonable salary, which a general rule of thumb is to either pay yourself what you would pay anyone else to handle the same responsibilities that you're handling for your own business or pay yourself at least 50% of your expected business net profits as a W2 salary. Payroll providers I like to recommend are QuickBooks Online Payroll and Gusto. Now, once that's set up and rolling, then you have officially become an S corporation, which can save you thousands of dollars in self-employment tax payments. But there's one scenario that can help you completely eliminate self-employment taxes altogether. So, let's talk about that one next.
What I'm going to talk about here is how to completely eliminate the big nasty self-employment tax. So far, I talked about option one, which is to reduce your business income as close to zero as possible. And we talked about option two, which is to elect your LLC to be taxed as an S corporation, so you eliminate the self-employment tax on your owner distributions, but you would still have to pay some with the W2. And now I want to introduce you to scenario three where you are a passive owner or limited partner. Because guess what? If you own a trade or business activity that you do not materially participate in, meaning you are more passive, then your income from that activity is not subject to self-employment taxes, which is huge, a complete gamecher. So now the question becomes, okay, how does the IRS distinguish between what is considered to be passive versus an active business? Well, I'm going to break it all down and talk about how you might be able to take advantage. I'm going to explain the rules for a passive versus active business, examples and best practices to qualify for passive income, and considerations and tax implications for both of these income streams. Let's go ahead and do some passive aggressive planning. Get it?
Number one, passive versus active business. Now, you might think a passive business is one where you just sit back and you don't do any work at all. But that's not exactly how the IRS sees it. Instead, they consider a passive business to be any activity that you do not materially participate in. Meaning, you are more of an investor rather than an operator. Whereas in the active business is one where you materially participate meaning you are involved in the day-to-day operations on a regular continuous and substantial basis. And the key words here are material participation. And the IRS makes it very clear in publication 925 what the rules around material participation are. Let's quickly go through them. So, you are considered to be an active participant of a business if you meet at least one of these seven tests. Number one, you work at least 500 hours in the business during the year, which works out to be a little bit more than 10 hours per week. Number two, your participation is substantial, meaning the business cannot run. It cannot operate without you. Number three, you work at least 100 hours and no one works more than you. Number four, your participation in multiple businesses exceeds 500 hours. Number five, you materially participated in any five of the last 10 tax years. Number six, it is a personal service business like you personally had a law firm or consulting or something like that in your contract where you materially participated in at least 3 years. And number seven, based on circumstances, if you regularly and continuously participated, the IRS still may consider you to be an active member. And so those are the seven tests. And if you don't pass one of these tests, then guess what? You can consider any money from this activity as passive income, and you won't need to pay any self-employment taxes.
Now, let me ask you this. When was the last time an accountant or tax preparer asks you if your business met one of these tests? I'll wait. Probably never, right? And this is only something that you would know. And I found after interviewing my clients is that sometimes they do not materially participate in their operations without even realizing it. Which brings me to the second part of this video. Examples of passive businesses. The IRS gives us some clear examples of what some passive activities look like and I can also share some based on my own experience as a tax professional. So on the IRS side, they view any rental business as a passive activity even if you materially participated in that activity. Of course, that means rental real estate properties, but also that can mean other rentals like rental boats, rental golf carts, rental equipment, so on. Basically, if you are leasing any assets, then the IRS would automatically view it as a passive activity. However, there are two popular exceptions. Number one, if you are a real estate professional, then your rental activities may be considered active income. And number two, if you lease property to customers for average period of 7 days or less, it can be considered active income. Now, in addition to rental activities, the IRS shares that if you owned any activity as a limited partner, then generally those profits are considered passive income. And so, if you are partnering with someone or investing and they send you a K Wayne with the box limited partner checked, then that would flow through on your tax return through a schedule E, which is passive income. So, boom. The IRS gives us rental activities and limited partners as examples.
Now, let me share some examples that I've seen from my own experience. The first case would be the entrepreneur with a new business or side hustle while maintaining a full-time job. In this case, since you're working more than 40 hours per week with your full-time W2 job, then you may find it difficult to pass the 500 hour test. So, the key question for you is, did you substantially participate in the operations? Meaning, can the business run without you? And what I found is that in some cases the answer is yes. For example, one of my clients worked as a full-time software engineer but also had a cleaning business on the side. Well, he actually didn't do any of the jobs. He simply ran ads and his contractors would handle everything from invoicing to cleaning to even getting five-star reviews. And so with us, he was able to completely avoid self-employment taxes. But unfortunately, in past years, his tax preparer didn't ask him the right questions, and he paid more in taxes than he actually needed to. And that's because he used schedule C instead of schedule E. So, that's one of my examples. Another example would be for people who have an automated online store. These are companies like dropshipping stores, Amazon FBA stores, print on demand stores where the suppliers handle the inventory, the shipping, and the fulfillment. And maybe you only spend a couple hours a week running and checking ads and making sure that the reports are positive. Well, because you are not actively participating in the daily operations, your income could be considered passive. As another example, if you own a faceless YouTube channel or a blog where you are outsourcing all the writing, the editing, the publishing, and again, you're only spending a couple hours per week to review the analytics, then that could also be considered passive. Now, my next example is a bit more obvious, right? And that is if you have a team that manages the day-to-day operations, then you're likely not materially participating. In fact, this is how I was able to turn my marketing agency into a passive business. We have a management team, we have team leads, and we have employees that handle everything from sales to service. And I just spend a couple hours reviewing reports. And then I have two meetings a week, one with my management team and one with my board where we make high-level decisions. And then finally, the last example I want to share is if you are buying an existing business or a franchise, but they already have a management team in place that will run the operations. For example, if you are acquiring a landscaping business that already has a team and a full-time manager to run it, and you just need to check financial reports and attend occasional meetings, then you're not materially participating in the operations.
Now before you decide to make this a part of your strategy, let's talk about number three, considerations and tax implications of passive income. Before you make your income passive or active, you need to understand this golden rule, which is passive losses offset passive income and active losses offset active income. That's extremely important. And so if you're doing tax planning and most of your income is passive, then your tax strategy needs to help you create passive losses and vice versa. If your income is active, then your tax strategy needs to create active deductions. If this is not done correctly, then you could find yourself with lopsided results. For example, if you have an active business that generates $300,000 in net income and then you have a rental property that is passive with a loss of $50,000, then you wouldn't be able to use the rental property loss to offset any of your active business income, and you would still pay taxes on the $300,000 net profit. But what some people would do in this scenario is they would make their rental property into a short-term rental with an average stay of 7 days or less or become a real estate professional, which then suddenly turns their rental activities into active income. So they could use that $50,000 loss against that $300,000 business gain. And it works the other way around as well. If you have $300,000 of passive business income, then you wouldn't be able to deduct any of those active losses. But in that same example, you would be able to deduct the $50,000 passive loss from the property. So, what I do with the passive income from my marketing agency is invest in passive rental activities like multifamily real estate apartments, and then that creates depreciation and passive losses that offset my passive income. Now, I'm simplifying things here to make the examples extremely clear, but there are some nuances, and I'll talk about this a little bit more in my section on real estate, but for now, it's really important that you understand that you want to strategize for your passive income a little bit differently than you would for your active income.
Here's one more important note, which is the tax implications that you need to be aware of. Specifically, if you make passive income over $200,000 for single filers or over $250,000 for those with a married filing jointly filing status, you must pay a 3.8% net investment income tax on that income. So, that's something to be aware of because as you are eliminating your self-employment taxes, you are introducing this other NIIT tax. But, of course, it makes more sense to pay 3.8% 8% than it does 15.3% as a self-employment tax. So from a pure tax savings standpoint, if you learn that you have a passive income business already or you have the means to convert it into one, then it's likely going to improve your tax outcome.
Next up, we're going to look at some ways that you can structure things if you have multiple partners with varying opinions on their tax strategies. If you have multiple partners in your business, then you know sometimes it can be difficult to get on the same page and that also applies with implementing tax strategy. For example, you and your friend may decide that you want to open a business selling clothes and after having some early success, you both decide that you want to be elected to be taxed as an S corporation to avoid paying some self-employment taxes. But it doesn't stop there because your partnership continues to grow. The business is doing well and now your tax burden is starting to get hefty. So you decide that you both should buy new business vehicles as a tax strategy. One owner wants to buy a really fancy Mercedes as their business vehicle and the other one is fine with a low-key Toyota. Well, of course, those are vastly different price ranges for those vehicles. And chances are if you are 50/50 partners, one partner is not going to want to pay for half of the Mercedes. So then what do you do? Well, let's talk about the options.
Option one is you set up the company as an S corporation with each partner as a shareholder in the business personally, which is a standard structure for a partnership electing to be taxed as an SC corporation. So in this case, the partners would need to work out the discrepancies amongst themselves, which maybe they can agree on a specific vehicle for both of them or work on a budget for each partner to apply toward their vehicle or simply live with the discrepancy without worrying about the fairness of it all. And while this could definitely lead to some disagreements and tension, it's not all bad because with option one, you have many positive benefits like there's still one company, one tax return, and one payroll account for the S corporation. So that makes it easier to set up and maintain. And because of this, it is the cheaper option. However, the major con is various owners cannot take advantage of tax strategies that help them without involving the other partners, which means there's overall less flexibility.
Moving on to option two, you could set up the company as a multimember LLC partnership with each owner having their own escorp that owns their percentage in the partnership. So instead of it saying your name as the partner, it would say your S corp business name. So the income from the partnership business would then flow down to your SC corporation, which allows you to reduce the self-employment taxes that you will pay. Plus, now you would easily be able to buy any business vehicle that you want in your S corporation without having to debate with your business partner or split up the funds however you guys want to. And structuring it this way doesn't just apply to business vehicles, right? It opens up tax strategy for you as an individual partner. So now you can decide whether or not you want to take a certain deduction or if you want to hire a child or if you want to contribute a certain amount to your retirement account. The major benefits of this structure is that each partner can now utilize tax strategies as they see fit and they still get the advantage of the SC corporation tax benefits of avoiding self-employment taxes. But it doesn't come without drawbacks which are now you have multiple companies which means there are more to manage. There are multiple tax returns. There are multiple payroll accounts meaning there is more to set up. There's more to maintain and it is the more expensive option. So to give you an idea, my firm would charge around $3,000 for option one, but more like $8,000 for option two. And these wouldn't be one-time costs. This would be your structure going forward year overyear. That being said, you should be making enough income and getting enough tax savings to more than make up the difference in structuring things this way.
Now, here's a very important note and why I only gave you those two options. And that is because an LLC can be owned by an S corporation, but an S corporation cannot be owned by an LLC. All right. So, I wanted to make this quick video for
partnerships out there wondering how to strategize for themselves without involving a partner. And so, now you should know how to.
Coming up next, what we're going to do is look at some ways that you can pay yourself as a business owner. Let's talk how to pay yourself as a business owner, or more specifically, how to pay yourself as an LLC owner. First, I'm going to focus on how to do this for all kinds of limited liability companies, whether you have a single member LLC or a multimember LLC with other partners. And then after that, we're going to discuss how to pay yourself as a corporation, whether you have an S corporation or CC corporation. And this video is very important because if you pay yourself too much, you might risk putting your business in a bad financial situation. And if you pay yourself too little, you might be doing yourself a disservice and overwhelmed by all the taxes that you owe as an LLC.
Now, if you Google or chat GPT how to pay yourself, they're going to tell you there are several ways like paying yourself a dividend, a distribution, a draw, a W2 salary, and more. But there is a right way and a wrong way to do this. In fact, you are not allowed to pay yourself a W2 salary when you are a owner of a business taxed as an LLC. The right way to pay yourself as an LLC is through what is called an owner's distribution, also known as an owner's draw. You can think of an owner's distribution as a transfer of money. You are simply transferring money from your business bank account to your personal bank account. You could literally write yourself a check, go to the bank, or simply wire the froms from your business bank account anywhere that you would like it to go.
With an owner's draw, you don't need to worry about setting up payroll accounts or withholding taxes or anything like that. It's actually a very simple concept and what most people think of when they think about paying themselves, but it is very important to remember our lesson on pass through entities because LLC's net income passes through to the business owner and is reported on their individual tax return. Basically, in the eyes of the IRS, the business income of a normal LLC is your personal income. For example, if the business earns $100,000 in profits that sits inside of your business bank account and you don't transfer any money from your business bank account to a personal bank account, then you're still going to pay taxes on the $100,000 in profits that the business made. Okay? To emphasize this further, if your business earns $100,000 in profits and you transfer $50,000 to your personal account, you still pay taxes on $100,000 in profits. So, I know I gave you example after example after example, but this is something that a lot of business owners get confused and it's worth reiterating because I can't tell you the number of times that I had people tell me their tax bill was wrong because they only paid themsel X or Y from their business. The IRS does not care how much money you pay yourself from your LLC. That's literally your business.
But if you want to hear from me and what my general advice is, let's talk about number two. How much should you pay yourself from your LLC? Because you're going to be taxed on your business income. You might be thinking, "Well, it's best to go ahead and pay myself 100% of my business profits since I'm going to be taxed on it anyway." But it's not always that simple. You have to think about what your business needs because of course you may need cash to cover some operational expenses or cover some payroll if you have employees or contractors. And cash is the bloodline and heartbeat of your LLC. In fact, 90% of businesses fail because they run out of cash. So, I want you to think of cash like fuel and your business like a vehicle. The less cash you have, the shorter distance that you can travel. And too many times, business owners cash out too much from their business and they don't leave enough to cover their business expenses.
At the same time, since you are not having taxes withheld like you would as a normal W2 employee, you need to think about how much estimated taxes you need to pay. Because if you don't, then you're likely going to get hit with a huge tax bill wondering how to pay it. And then you're going to have to get on a payment plan with the IRS or an installment agreement. and then you're going to be playing catch-up for the next 5 to 6 years, which is what we don't want to happen. The worst kind of debt to have is with the IRS because they will literally levy your property, which is basically seizing your personal assets to satisfy your tax debt.
So, what do I suggest? Well, you're watching this video, so you shouldn't be facing this problem in the future since I consider you to be someone who is proactive in planning ahead. But as a best practice, I like to see my clients have at least two bank accounts, one with at least three months of operational expenses in cash. This will provide you with some security and peace of mind that your business can stomach any unexpected losses and be able to stay afloat. In the second bank account, I want you to fund with at least 25 to 30% of your net income to pay for your taxes. Whether that is estimated tax payments to the federal and state governments, payroll taxes or sales taxes. And a third bank account, which is optional, would be to set up an account for future business investments or strategic goals. And of course, you can use your own discretion to fund it with whatever amount you want. Now, as a quick pro tip, if you do use this account, then I would suggest getting a business savings account that earns a little bit of interest over time. After those two to three accounts, if you would like to pay yourself, then you're pretty much in the clear to take any remainder amount as personal income. Any excess income can be paid to yourself or your partners in the form of owner distributions according to your respective equity positions. And that's it. That's how you pay yourself as an LLC owner.
Now, let's move on and talk about how to pay yourself as an escorp owner. How to pay yourself as an SC corporation. Well, according to the IRS, S corporations must pay reasonable compensation to a shareholder employee, which is basically an owner who works in the business. So, the next logical question becomes, okay, what exactly is a reasonable salary? And doesn't it make sense to just pay ourselves the highest salary possible? Well, not exactly. You see, the profits you make from the escorp and distribute to yourself as an owner shareholder are not subject to self-employment taxes. And because of this, the distribution, at least in the eyes of the IRS, is taxed as passive income on your individual tax return, where you now have to pay your typical federal and state tax rates, plus any net investment income taxes, which as we discussed is actually a major benefit of electing your LLC to be taxed as an S corporation. However, when you pay yourself as a W2 employee, you still end up paying these self-employment taxes, which are social security and Medicare taxes on your W2 salary. Which means the lower your salary is, the lower your salary that you take, the less self-employment taxes you will have to pay. So technically, if you paid yourself a $1 salary, then you will be kind of gaming the system by basically eliminating your self-employment taxes. But of course, the IRS wouldn't allow this, which is why you must pay yourself a reasonable salary. Starting to make sense, right?
Now, the fact is, if you don't pay yourself correctly, the IRS has the authority to reclassify any payments made to the shareholder from distributions to wages. Essentially meaning you would need to pay back employment taxes. So, the big question is number one, how much should you pay yourself? Well, there isn't a magic book with all the rules and the salary options that the IRS allows. Instead, they leave it up to your discretion as a shareholder and mainly they use five tests to determine if it's reasonable. These are the factors. Number one, the duties performed and the skills required to do the work. Number two, the industry and market standards. What other similar positions in the same industry and location may make. Number three, the number of hours worked and the contributions made to the business. Number four, your own experience and qualifications such as your education levels, certifications, and past work experience. And number five, the company's profits and revenue. Because in general, if you have a new business and you're not profitable or making less than $40,000 in consistent profits, then the IRS is unlikely to classify your profit as wages. Now, if you are making over $40,000, then a general rule of thumb or a safe range is to give yourself a salary of 40 to 60% of your business profits before taking a distribution. However, I do see business owners and accountants make this mistake when they over rely on the 4060 rule because in some cases, taking 40 to 60% of your business profits is too extreme. For example, let's say your business profits are $600,000 and you take 40% of your profits as a salary, which is $240,000 per year. But when you look at your responsibilities, the main thing you do is run ads to your online drop shipping store. And for the most part, once the ads are set up, you just monitor the performance. Well, it is highly likely that you could find an experienced advertiser who could run the ads just as good, if not better than you, for a lower salary, which is where you could rely on a website like Glass Door, Indeed, or salary.com to see what the going rates are for experienced advertisers in your area and pay yourself that as a reasonable salary. Now, if you face an audit or you are just the type of person that wants to be extremely precise with your salary, then you can pay for a report that defends your position. And these reports are done by expert companies and they range from usually $500 to $1,000.
Okay, so now that you know how much to pay yourself, let's talk about how to pay yourself as an ESCORP owner. And this part is all about setup. What you need are number one, an EIN number or employer identification number if you haven't already. It's free and easy to get one on the IRS website. Then number two, you're going to want to get a state withholding tax account number. If you are required to pay state income taxes, then you must register an account. Each state process is going to look a little bit different, but it usually involves going to your state tax center. For example, here in Georgia, you would register at the Georgia Tax C Center's website. And then once you have that, number three, you would register for unemployment insurance or workers compensation because as an employer, you're going to be required to pay unemployment insurance taxes, usually through your state's Department of Labor website. From here, you can move on to number four and set up payroll. I recommend QuickBooks Payroll Online or Gusto to handle all the deposits, all the withholdings and unemployment payments for you. They will also help you with federal state tax forms and filings like the 941s, the 940s, the W2 forms, the W3 forms, and any other forms unique to your state. Then all that's left to do is number five and run payroll. So with QuickBooks, you can put in the salary you want to pay yourself in the frequency that you want to get paid, whether it is weekly or monthly, which by the way, I recommend it being monthly if it's your owner salary so that it is easier to manage. And then the system is going to automatically calculate how much to pay and how much to withhold based on the salary that you add. From there, you can set up auto payroll and add notifications so you always have several reminders of what is happening. And then boom, you are now set up to pay yourself a reasonable escorp salary.
But what if you have other people working for you like contractors or employees? How do you handle that? Let's talk about that next. Let's look at the best way to pay your team by the two options, which is a 1099 versus W2. So, without wasting any time, I'm going to tell you from a pure pure tax savings perspective, hiring someone as a 1099 versus a W2 is going to save you more money. Let me illustrate with an example. Let's say your business makes $100,000 in revenue and you decide you want to hire someone to do the work for $50,000. Well, when you're hiring someone as a 1099, you wouldn't have to pay any payroll taxes and you would be able to deduct their entire $50,000 payment. Versus, if you hired someone as a W2 employee, you would have to pay at least half of their payroll taxes, which for simple math would be about 7.65% of their salary, which is $3,825. But you would be able to deduct this additional cost as the employer. So technically, you would get a bigger tax deduction overall, which would be $53,825. And that's where people look and say, "Okay, well, hiring a W2 employee is going to save me more money in taxes." But we have to look at the total picture because in the 1099 column, the profit is $50,000, but in the employee column, the profit is $46,175. And if we assume a tax rate of 25%, then you can see the difference in take-home pay is nearly $1,000 more in this scenario if you hired the person as a contractor instead of a W2 employee. And so, as your business grows and scales, this margin becomes even greater. Plus, the person receiving a 1099 generally makes more income because now they can maximize their deductions to increase their own take-home pay.
But, and this is important, just because you save more money paying someone a 1099 versus a W2 does not mean you should. In fact, if you mclassify a worker as a 1099 instead of a W2 employee, you could face financial and legal consequences like owing back payroll taxes, penalties for failure to withhold taxes, interest on any unpaid taxes, and possible fines for intentional mclassification, which I see come across my desk every now and again. Therefore, it is very important that you know the differences between what is a 1099 versus W2 employee.
So, a 1099 worker or an independent contractor generally provide specific services as defined by a written agreement or written contract. So, freelancers, consultants, drivers, even some physicians are declared as independent contractors. So, they are business owners themselves who likely work with multiple clients. The first step to hiring an independent contractor is establishing an agreement or contract for which the business and contractor will work together. Typically, this contract would define the specific outcome to be provided and the period of time for which the work would be performed. And because of this, independent contractors have complete control over how they execute your contract. They get to choose their hours, their resources, their process, even potentially their team. And since your level of control is relatively low, your financial and legal responsibility is also low as well. You don't have to pay payroll taxes or offer any benefits like you would with a W2 worker such as workers comp or health insurance, PTO, or even overtime pay. So, by hiring an independent contractor, you're able to save a little bit more money, but you lose control in the way things are handled.
Now, let's move on and define what is a W2 worker. So, a W2 employee is the default classification of someone working for your company. Unlike an independent contractor, W2 workers are not business owners, and they usually work solely for your company, which means you have full control. You choose their hours, you provide them resources, you put the teams together, and you lay out the processes. And if you're not happy with their performance on the job, most states will allow you to terminate their employment at any time. Whereas with an independent contractor, you are expected to uphold any established agreement for the specific period of time, even if you're not happy with the performance. Now, there are some laws and regulations for W2 employees. First, of course, you must pay them a minimum wage for the time that they work, which is set by state and federal laws. Also, as we outlined in the earlier example, you are expected to withhold payroll taxes on behalf of your employee, such as social security or Medicare taxes. And benefits such as health insurance, retirement contributions, and paid time off can be other incurred expenses. Whereas with an independent contractor, they are expected to handle all these other benefits on their own.
Now that you understand the difference between a 1099 and a W2 worker, let's discuss the IRS rules for classifying a worker. Because once again, if you don't follow these rules, you put your business in jeopardy. The good news is the IRS provides us with three categories of common law rules to help us determine the correct classification. Number one is behavior where you ask does the company have control or have the right to control what the worker does and how the worker does his or her job. Number two is financial where you ask are the business aspects of the worker's job controlled by the payer. Things like how the worker is paid, whether expenses are reimbursed, who provides the tools and supplies and so on. Number three is the type of relationship. Are there written contracts or are there employee type benefits that is like a pension plan, insurance, vacation policy and so on and will the relationship continue and is the work performed a key aspect of the business? And so if you answer to any or all three of these questions as yes because the business has a lot of control then your team member needs to be classified as a W2 employee. Otherwise, you can save some money by going with a 1099.
But regardless of which route you choose, let's discuss how to actually pay your team. There are three major things you need to substantiate the classification for any worker you hire. First, of course, you want to establish a written agreement between your company and the individual. This is usually in the form of an offer letter or a service agreement contract. Once that is executed, then you need to have them complete some tax forms. So 1099s must complete a W9 providing you with their name, their address, and their taxpayer identification number. W2 employees must provide you with a W4 form giving you similar information, but on this form, they can also add deductions or additional withholdings. If you're using a provider like QuickBooks Online or Gusto, then these forms can be sent out from their software systems to your team members and then automatically will factor their forms into payment calculations such as their withholdings. From there, with your 1099 contractors, you would schedule and deposit money according to your agreement. And then for W2 employees, you would enter their salary and agreed upon pay schedule. Then you have the option to do automatic payroll or send payments manually. After that, congratulations. You are now compliant in hiring your new team members.
I want to quickly explain the difference between a tax credit versus a tax deduction because I literally had a client confuse this so badly that when he saw his tax outcome, he literally cried on the phone with his wife. And it was really heartbreaking to hear. You see, because he started a new business and spent over $50,000 in expenses trying to gain some traction. Well, things didn't grow as quickly as he had hoped, but he was still full of optimism, thinking, "It's all good. When I file my taxes, I'm going to get a lot of that money right back." And unfortunately, I had to break the news to him that there's a big difference between a tax deduction versus a tax credit. And I never want to see someone go through that again.
So, what is a tax credit? Simply put, a tax credit directly reduces the amount of tax that you owe by giving you a dollar for-doll reduction of your tax liability. For example, if you owe $2,000 in taxes and then you get a $2,000 tax credit, then your tax liability becomes zero, aka you won't pay anything in taxes. On the other hand, a tax deduction reduces how much income is subject to taxes. So, a deduction focuses on lowering your taxable income, not your tax liability. Now, your taxable income is going to be based on how much money you made in the tax bracket that you fall into. For example, if you fall into the 24% tax bracket, then a $2,000 deduction saves you $480 on your tax liability, which is 2,000 * 24%. Now, immediately just based on that example alone, you probably noticed that tax credits give much more tax savings than a tax deduction. I mean, you have a $2,000 savings versus a $480 tax savings. And while that is normally true, that is not always the case.
Let's go ahead and look at number one, the catch when it comes to tax credits. So, some tax credits are non-refundable, which basically means that if you don't owe a lot in taxes, you may not get the full value of the credit. Say, for example, if you owe $500 and you get a $2,000 non-refundable tax credit, well, because you only owe $500, your tax credit basically reduces your tax liability by $500, and you don't get to utilize the full value or get a refund, hence the term non-refundable. However, there are some tax credits that are refundable. The most popular ones that you've probably heard of are the earned income tax credit or the child tax credit. These two credits will allow you to wipe away some of your tax liability and potentially give you a tax refund check from the IRS. However, there are specific requirements such as income limitations set by the IRS that you must meet in order to qualify for non-refundable and refundable tax credits. And because of these limitations, it makes most tax credits difficult to qualify for for households with over $250,000 in AGI or adjusted gross income.
Plus, there are some advantages of number two that tax deductions have over tax credits. Number one, deductions, especially business deductions, often do not have any limits. You can deduct as many expenses as you want to, no matter how much income you earn. Which makes this combined with number two much more favorable because many deductions that exceed your current year income can be carried forward to future tax years. As a very simple example, if in tax year 2025, you had $1,000 in taxable income, but you had $2,000 in deductions, then in the tax year 2026, you may be able to carry forward a portion of that $1,000 loss to be applied to your 2026 income. Now, the amount of time and or the percentage that can be carried forward depends on the type of loss. For example, net operating losses from businesses can be carried forward indefinitely but are limited to 80% of taxable income. Capital losses from assets can be carried forward indefinitely but are limited to $3,000 per year to offset other forms of income. Passive activity losses from passive income like rental properties can be carried forward indefinitely but can only offset passive income. and charitable contributions can be carried forward at most five years. So, in the case of my client story that I opened up with earlier, the good news is he's going to be able to carry forward those losses and wipe off nearly $50,000 of future business income as his business becomes more profitable.
That being said, let me share number four, my advice on tax deductions and credits, which is you want to make sure you utilize every single deduction and credit that you qualify for and positively impacts your business or personal financial future. The key words there are ones that you qualify for and ones that positively impact you and your business because having a profitable business is always going to be the most important thing that you can work on. At the end of the day, I would rather you focus on making $1 than saving 35, which the 35 cents represents the highest tax bracket currently. Now, I'm not one of those tax preparers that will tell people to start a business, take all the losses you possibly can, and just write off everything. That is the exact opposite of what most successful people do who are leveraging the tax code, and are actually doing well. Plus, you can only do that for so long before the IRS catches on and starts looking deeper into your business losses, causing you to have to repay or going through an audit and potentially facing severe penalties.
All right, so hopefully that saved someone out there who doesn't quite know the difference between tax deductions versus tax credits.