Transcription
Choosing the wrong entity structure could cost you six figures in taxes. It is the single biggest mistake that I see investors and entrepreneurs make.
Most entrepreneurs, investors, they'll just set up an LLC and they say, "Hey, in fact, I'll ask them. So, tell me how your business is taxed. I'm an LLC." What they don't realize is to begin with is LLC is a legal designation, not a tax designation. So, if you tell me you're taxed as an LLC, I don't even know how you're taxed because there is no taxed as an LLC.
Let's break it down just a little bit. You're either taxed as a corporation and as a corporation, either an S corporation or C corporation. You're taxed as a partnership, either a general partnership or a limited partnership, or you're taxed as a sole proprietorship. Those are your choices.
Now, here's what I love about LLC's. LLC's are really flexible. You can actually choose any of those. So, when we talk about tax structure, we're not talking about LLC versus partnership because an LLC can be a partnership. We're going to talk about corporations versus partnerships versus sole proprietorships. So, the reason you use an LLC is solely for asset protection. I'm not an asset protection attorney. I'm not an attorney at all. So, I'm going to refer you to asset protection attorneys to talk about the asset protection benefits of an LLC. What I like about them is I like being able to choose um what's good for asset protection, in a lot of cases that's going to be an LLC, and choose my entity. And what's even more is sometimes I want to be a partnership starting out and then become a corporation. And the only way to do that is with an LLC.
So, here's the thing. People think, "Okay, I'm L I'm I I set up an LLC. I'm done." You're just starting. You are far from being done. Because again, if you set up an LLC, by the way, and and you set it up just by yourself, you're a sole proprietorship, which is the worst thing to do from a both a tax and an asset protection standpoint. You want to do is first of all, you don't ever want to be a sole proprietorship. Please don't be a sole proprietorship. Um, that means you're going to be on a schedule C if you're a business or a schedule E on your personal tax return if you're uh if if you're doing rental properties, even short-term or long-term schedule E.
Why? Why is that a problem? Because you have a much higher chance of being audited by the IRS because IRS doesn't trust you. Why don't they trust you? Because you only have one financial statement. You have a profit and loss statement or an in what's also called an income statement. You don't have a balance sheet. And so they don't trust you. You It's like one-sided entry. It's like, it's kind of like saying, "Well, I I I caught a fish." If you had two sides, you go, "I caught a fish this big, this big, this big. I caught a fish this big." Right? That's really what you're saying. If you're a sole proprietor, either as an investor on a schedule E or a business owner schedule C, plus you create self-employment tax issues with your business, just don't be a sole proprietorship. I used to think it was okay at certain points. I don't think so. anymore.
So then the question is, okay, so when do I use a CC corp, when do I use an S corp, and when do I use a partnership? Because the entity structure from a tax standpoint is going to determine how much tax you pay, whether and how you can shift income to other brackets, how you pay yourself, and how much of your profit you get to keep and reinvest. Entity structure is not just a legal thing.
So, here's the challenge with a lot of attorneys. They'll give you the legal structure, but they're asset protection attorneys. I have friends, good friends, who are asset protection attorneys. The really good asset protection attorneys, they let the tax people do their job. That's me. Now, I understand asset protection because I've been studying this for so long, but I always work with an attorney on this. But here's the thing. The tax law is much more complicated than asset protection law. The tax law is thousands of pages. The asset protection law is like 50 pages. So, it's just we always start with the tax side of things. I'll do my best from a legal standpoint and then we'll talk to the attorney and have them make sure it works from an asset protection. But most people start with the asset protection and forget that they really ought to be starting with tax. That's the that's the most important part because it makes such a big difference on how much tax you pay.
Simply, for example, going from a sole proprietorship to a single member SC corporation can save you as much as 15 or $20,000 in taxes a year. $15 to $20,000 simply by being S corporation instead of being a partnership. I mean, it is enormous amounts of money.
So, let's go back to the LLC for a second. Everybody's favorite default. I'm going to be an LLC. That's fine. You're an LLC. It's easy. It's cheap. It's, you know, it's common. It's great. Gives you asset protection. But again, LLC is not a tax strategy. Like I said, by default, a single member LLC is a sole proprietor. A multimember is a partnership. That means as either a sole proprietorship or a partnership, you're paying 100% of the income is subject to self-employment tax. How much is self-employment tax? Anywhere from 15.3% to 16.2% on top of your income tax. That's right, an extra 15 or 16% on top of your income tax.
So, why not set up as an SC corporation, for example, and eliminate a lot of that self-employment tax? The other thing is with a sole proprietorship, it's you're you're having it's much more difficult to shift income to a lower bracket um to split the income. Now, you can if you're a partnership, you can split it that way. And here's what I'm going to tell you. All of these entities that I'm talking about are good in the right situation and bad in the wrong situation. So, they're not good or bad entities. They're good or bad depending on the situation you have.
So, let's start with S corporations. So, if you think about Robert Kiyosaki, my friend Robert Kiasaki's cash flow quadrant, he goes that's the S quadrant, right? The E quadrant is employees. S quadrant is self-employed or small business. That's where S corporations make the most sense. Why is that? Well, first of all, we want to get rid of that sole proprietorship or general or partnership so that you're not paying self-employment tax on all your income. But second of all, it's because you're probably taking all the money out. If you're a small business owner, basically, for the most part, you own your job, right? Let's face it, small business owners own their job. Well, that means you need the money. Well, you don't want to pay tax twice. If you were a C corporation, you'd pay it once at the corporate level and once again when you take a distribution. In an S corporation, you only pay tax once, and that's at the individual level. So, the corporation itself doesn't pay tax.
Well, that can be really good because you should be, by the way, you've heard top tax bracket is 37%. But not for an S corporation. An S corporation, top tax bracket is 29.6%. Because we get this qualified business income deduction. But again, you've got to plan for that because if you don't take the right salary and you don't plan right for your S corporation, you could lose some of that qualified business income deduction and end up in a higher tax bracket.
So, here's what you need to do. I always say it's okay to act small, but you've got to you or think small and you might be a small business, but you've got to act like the big guys. Okay? So think of that yourself as a real business. So what does that mean? Well, it means not only do I have an income statement, I have a balance sheet. Preferably, you also have statement of cash flow. But let's just talk about the income statement, balance sheet. An S corporation forces you to have an income statement and a balance sheet. That's why S corporations are audited about 80% less than schedule C sole proprietorship. Okay? So that that's the first thing is that you've got to act like a real business.
So in a real business, what would happen? Well, you're an employee of the company. And how do you get paid as an employee of a company? You take a salary. Well, how much salary do I take? Well, of course, we want to take the least amount possible because salary is subject to social security tax, which is the equivalent of self-employment tax. So, we want to take we want to minimize that salary. However, we do have to take a reasonable salary. So, here's the way I look at it. Look at what would you pay somebody else to do your job in the company? Not as the investor, not as the owner, but your job in the company. What would you pay somebody else to to do that job? That would be a reasonable salary. Now, you can be on the low end of that range. That's fine, but that would be a reasonable salary. I like to say that um you know if you really don't know what a reasonable salary is and you can look it up online but if you pay 40 to 50% of the money you take out is taking out a salary you're probably okay. I've not seen the IRS challenge that. There's no guidelines on that. Um I'm not telling you what the law is. I'm telling you I've just not seen the IRS challenge that.
So what do you do with the rest of the money? So you take some let's say you take 50% out. Let's say you make $100,000. 50% comes out of this five $50,000 comes out of a salary and $50,000 comes out of a distribution as a distribution. The distribution is not subject to social security taxes. That that by itself is going to save you $10 to $20,000 a year. Okay? You can see I mean if I if I can cut my um $15,000 down to $7,500, right? That would be 100 at $100,000. That's $7,500 that I put in my pocket and I never have to pay it back. What if I I'm at $200,000? So, it gets bigger. The bigger your income is, the more savings there are with the SC corporation. But again, S corporation is a great place where you build a business, but you're taking most of the money out every single year.
One caution. Please, please, please do not put real estate into an S corporation, investment real estate. Why do why did I say you want to be an S corporation instead of a partnership or sole proprietorship? Well, the reason is self-employment tax. But there is no self-employment tax on real estate rental. So, why would you give up the flexibility of a partnership? Now, I am a I'm a partnership expert. That is my technical expertise is partnerships. That's what I did in the national tax office of Ernst & Young. I was on the partnership team. There were five of us that nationally to handle the partnership team. That was my team. So, I love partnerships. So, I try to avoid corporations because they've got more rules to them than partnerships. However, an SC corporation makes so much sense if it's a business subject to self-employment tax. But real estate makes no no sense. On top of that, for whatever reason, you have to pull that real estate back out of your business. Guess what happens? You have to pay tax. The S corporation pays tax as if it sold the property to you at fair market value. So, let's say all you're doing is refinancing it. You're going to put it into your personal name, refinance it, and then deed it back to the s the the the the company, the LLC, right? But if the LLC's an S corporation, that getting it out of the company, that's a distribution and it actually creates a tax liability. So, no reason to put investment real estate into an S corporation. So, please don't do that. If you hear people doing that and or if you've done it, you need to sit down with your tax advisor and figure out a way to take care of that because it can be an issue.
Now, let's talk about C corporations because I hear a lot of small business owners saying, "I'm just going to be an S corporation. I'm done. I'm going, "Yeah, but really, are you really done?" Because you're giving up a lot of potential tax savings. Here's why. See, let's say you're not taking all the money out. Let's say you're reinvesting this because here's what we know as a small business owner. So, as an employee, remember, we get paid once. We render our services, we get our paycheck, and that's the only pay we ever get. As a business owner, we get paid twice. This is the reason to own a business. To me, the primary reason you get paid twice because you get paid once in the income that comes in, but what does that income create? It actually creates value of the business. So when you can then sell the business down the road and you get that income that's built up. Let's say you get a multiple of that income and you get to sell it, you get capital gains on it. But here's the point. You're getting the income once, you're selling it and getting the income again. So you get paid twice with a business.
Now with a C corporation, if you're going to leave the money in and you're going to keep building it up, guess what? C corporation maximum tax rate 21%. Versus that 29.6% almost 30% if you're an S corporation. So wouldn't you rather be a C corporation? Yes. If I'm not taking all the money out, right? If I'm just taking a small salary out, that's fine. We're going to take salary out of an S corporation anyway. Now I can take that salary out, but I'm going to leave the money in the C corporation and it's going to compound because I only have a 21% tax rate instead of a 30% tax rate. So it's going to compound that much faster. On top of that, if I leave it in for 5 years before I sell the business and I sell the actual business and of course I dot my eyes, cross my tees, do everything else I need to do with a really good tax advisor. When I sell that business, I could pay zero capital gains tax. That's called section 1202. So, if you haven't se heard of section 1202, you need to absolutely talk to your tax advisor about section 1202. Why haven't you talked to me about section 1202? Should I be an C corporation instead of an S corporation? And not only do I get a lower tax rate now, but I pay no tax when I sell the business. Doesn't I mean, it almost sounds too good to be true. And yet, it's absolutely true. And I've actually defended 1202 on an audit. Um, it's not a big deal because the law is pretty clear on what it means.
So, here's the reason the wealthy use C corps. They're retaining the profits at a lower tax rate. Fringe benefits like their health insurance and healthcare. Instead of having this limitation on how much you can deduct like you do through an S corporation, you can have unlimited deductions. So, you can have $50,000 of medical deduction and take $50,000 in a C corporation. That's the one big difference on what's deductible to a C corporation versus an S corporation. You might reinvest the profits, research and development, marketing, uh, customer base, intangibles, and you're creating this long-term holding company. C corporations can be very very powerful for legacy planning as well because remember if the C corp another way for the C corporation not to be taxed let's say you die owning the C corporation what happens to that capital gains when you die it disappears you have no capital gains anymore so your heirs can sell your business to let's say one of your partners whoever one of your business associates they can sell the business and not pay any capital gains Right. So, C corps can be very important in your planning.
Okay. Now, we're going to take the same business with $250,000 in net income and run it through three different structures. The first one, we're going to run it through a sole proprietorship or partnership. So, all of them are going to be LLC's. It's just going to be how are we taxed? We're getting tax as a sole proprietorship or partnership, as an S corporation or C corporation. The LLC is taxed as a partnership or sole proprietorship. You got the net income of $250,000. Your self-employment tax is going to be roughly $30,000, a little more less. Income tax going to be about $60,000. So your total tax liability is about $90,000. Well, what does that mean you keep? That means you keep $160,000.
But let's say instead you're an S corporation. And let's say you say, "Well, I think a $100,000 salary is appropriate." Now, my payroll tax is only $15,300. My distribution of $150,000 pays no self-employment tax. My income tax is also could be lower. Um, so let's say my income tax is about $55,000. So my total tax is right around $70,000. So instead of a tax of 90,000, I have a tax of $70,000. Okay? Which means that what I'm keeping is out of the 250, I'm keeping $180,000. Okay? Now, $180,000 is a lot better, right, than the alternative of $160,000.
Now, let's say that I leave it all in the company. I'm a C corporation. You decide, hey, I'm going to reinvest a lot of my money in the business. I'm only going to take out my regular salary, but I'm going to revest the rest in my business. I'm going to be a C corporation. What does that do? Well, it means that we still have the payroll tax, $15,000 approximately on the $100,000 of salary. We also are going to have personal income tax on that $100,000. Let's say it's about $15,000, could be more or less. And then another $30,000 approximately 30,500 uh on the 150 that we've left in. Right? So, we'll say that's roughly 30, which means we have a total of about $60,000. So, we've gone from 70,000 to 60,000 because we didn't take the $150,000 out of that. Okay? So, what that means is is that now we have 190,000 left in the company. So, we're actually getting to use $190,000, right? Both inside and out, we get $190,000. So what you see is there's an incremental increase going from uh the partnership sole proprietorship where you only keep 160,000 right to the S corp where you keep 180,000 to the C corp where in this case you keep 190,000 on top of that in the C corp if you set this up under 1202 when you sell the business you pay zero tax.
So, same $250,000, but with the right structure, you're saving $30,000 or more in tax every single year. You're not subject, you're not ignoring and putting blinders on and saying, "Hey, I just don't want to be audited." You are more likely to be audited, by the way, as a sole proprietor or partnership than you are as an S corp or a C Corp. So, you're not helping yourself. You're paying higher taxes and have a higher chance of being audited.
Now, one thing we can do which I love doing is I like layering entities. In other words, I like using multiple entities in the same for the same taxpayer. So, let's say you run a seven figure consulting business, you use an S corporation, you pay yourself salary, save on self-employment tax. You have a C corporation, hold your brand, the IP, license, the IP, and you maintain the retained earnings for uh marketing, research, and development. And then um you might have an LLC as a management company. I'd have that still be an S corporation. That's fine. Which leases staff uh and equipment. Great. Now what we've done is we've split it up. Split up your income among multiple entities. We've leveraged the fringe benefits. We've created we've got good asset protection and all paying far less tax.
Now I'm going to give you one more. I'm going to tell you my one of my favorite structures. Um, and I'm gonna tell you, and this this is free. I normally charge a lot of money to tell people the this structure, but it is one of my favorites. Let's say you have a partner in your business. Well, if you're an S corporation, and let's say you're 50/50, that's fine. And you could be an S corporation. What's the problem with that? Well, there's no flexibility in S corporation. So, that means that if the business earns $500,000, you each get $250. And if you, let's say you each had a car that you used in the business, you'd each get 50% of the deduction for the other person's car. But let's say you buy a $100,000 SUV and they buy a $30,000 used Toyota. Well, they're sharing the cost of your SUV and you're sharing your deduction from your SUV.
What do you do instead? This is my one of my favorite structures. Here's what I do. We actually set the business up as an LLC taxed as a partnership. You go, "Wait a minute. You just told me not to do that." Okay, but we're not done yet. Because you in you own your 50% through your own SC corporation and your partner owns their 50% through their SC corporation. What does that do for you? Well, your partner's vehicle, that $30,000 vehicle, is paid out of their S corporation. And your $100,000 SUV is paid out of your S corporation, which means you get the deduction, and you pay for the cost of the S of the SUV, they get the deduction, they pay for the cost of their $30,000 Toyota. See how that's much more fair? You've got a lot more flexibility when you combine the entities than when you just use a single entity.
So, where do you start? First thing is look at your current structure. Have your CPA draw an entity map. So it literally is a diagram. Okay? Some people call it a structure diagram. I call it an entity map that actually maps out what all of your entities are, who owns it, what percentage, and everything. It's a visual. We actually at my company um PLA software, we actually created a software just to make entity maps. That's how important these things are. So, um, what why is that important? Because then I can send that any new app to an attorney and they know exactly what they're looking at and they say, "Hey, wait a minute. Could we do this or this?" Yeah. Okay. But they have a picture. Picture is worth a thousand words. Okay.
So, first you look at your current entity structure. Does it give you what you need? Then sit down with a good tax advisor that actually specializes in tax strategy. Right? Tax returns happen at the end of the year. Tax strategy happens all throughout the year and come up with a tax strategy. And this tax strategy almost always needs to begin with your entity map because about 50% of your tax savings from your tax strategy is come from how you set up your entities. It's that big of a deal. Work with a team who understands entity design, not just accounting and tax return compliance. You're not going to be able build wealth by default. Your single biggest obstruction to reaching your wealth dream is taxes. It is your single biggest obstruction. It is the single biggest weight holding you back. What we do is we build wealth by design. We actually design a wealth and tax strategy.
See the government gives incentives to those who do what the government wants you to do. They invest in uh create jobs. They create housing, create energy, um they invest in agriculture, and they invest in the economy in general. That all of that all those incentives start with doing the right entity structure. See, I'm not going to put investment real estate in the same entity as I put my business. And it may depend on what state I'm in. So, there's a lot to this.
Now, I don't sell LLC's, C corps, S corps. That's not my business. I'm here to sell you on thinking differently. Understanding that if you want to have what the wealthy have, you have to behave like the wealthy. If you want to have what the wealthy have, you have to behave like the wealthy. What do they do? They have really good entity structures. They have they're using all the different entities so that you're not just making money, but you're keeping your money.
Now, if you're wondering which entity is right for your business, I put together a free guide called Which Entity Is Right For You. Inside you'll get a side-by-side breakdown of sole proprietorships, partnerships, S corporations, and C corporations, and a flowchart to help you decide based on your income and your goals. This is the same framework I use with my private clients to save them millions in taxes legally. Just click the link below to download it free and start structuring your business like the wealthy do strategically.
Now, here's a number that should scare you. The average person spends 20 years of their life working just to pay taxes. That's two full decades gone. I call it a prison sentence. But if you want to take that time back and turn your taxes into a wealth building tool, watch this next video right.