May is an important month in the tax world. Business owners spend it focusing on second-quarter goals while simultaneously planning for second-quarter taxes, which occur in June. It can be a tough month as April likely left many bank accounts lighter between paying the prior year’s tax owed, the current year’s quarterly tax payment, and the possibility of maxing out HSA and IRA accounts. If a company extended its return in April, that could potentially culminate in one very large extension payment.
When we are determining taxes owed in April, it leaves a quick turnaround as first-quarter estimates are based on income from January through March. We prefer our clients to be informed, which leads to better financial decisions. So, we’re going through the work of actual amounts owed and not just shortcutting to safety estimates as the default.
As a business owner, one of the most confusing things is understanding the difference between how you’re taxed and how your business is taxed. To clear things up, we’ve dedicated a blog with a special focus on pass-through entities and taxes incurred.
Understanding Pass-Through Entities
Pass-through entities are a type of business structure used to avoid double taxation, such as a corporation that is taxed at both the business and personal level. A pass-through entity is a structure in which the taxes on the business revenue are directly passed to the owners or investors. Common examples of these entities are partnerships, S-corporations, and limited liability companies (LLCs). What this does is moves the income to the owner’s personal tax return, which then can be reduced by other factors (credits, tuition, itemized deductions, etc) before determining the tax owed. Pass-through entities are also known as flow-through entities (FTE) because the income “flows through” to the owner.
The owners need to figure out the net income from the business at year-end to determine what’s taxable and what isn’t. Certain tax adjustments may need to be made to the books to determine the taxable net income such as penalties, entertainment, inventory, etc. The income is then split based on the ownership percentages of each owner, which they then report on their individual tax returns.
Important Tax Considerations for Pass-Through Entities
Some other things that business owners or investors should watch out for when considering taxes for pass-through entities:
- Cash flow does not equal taxable income.
- Money that is invested in inventory does not reduce income until the item is sold.
- Money that is used to pay debt principle is also not deductible, as the initial capital inflow was not taxable.
These flow-through entities pay taxes based on what the company reports for taxable net income. It’s not based on how much cash is in the company, how much the owner did or didn’t take out, or whether funds were reinvested to grow the company. This tends to be one of the biggest misconceptions of what business owners are taxed on. If at the end of the year your company’s bottom line on the income statement shows an income of $500,000, the owner(s) will pay taxes on that amount regardless of if they pulled out the full $500,000 or left every penny in the company.
Partnerships: Self Employment Taxes
A partnership is a business that’s owned by two or more people. Each owner in the partnership contributes money and labor, while also sharing in the profits and losses. Partnerships require formal registration with stated legal ownership percentages. Partnership returns are filed on Form 1065, but they’ll eventually flow through to the individual return. The partners will then pay federal tax at that level.
For a partner who is actively involved in running the company, the income is subject to Self-Employment (SE) taxes. SE tax is the same tax paid by employees and employers, but instead of it being split between the two, it falls solely on the individual. Additionally, the partner receives a tax deduction for half of the amount on their return as well.
Partnership Tax Example
Jack and Joe are 50/50 business partners. The business made $300,000 in profit. Due to current supply chain issues, they decide to use $150,000 of cash to buy more inventory for a large upcoming project they have. They also had paid off a debt of $90,000 during the year. Based on cash outlay, they decided to split the remaining draw of $60,000. As a result, they’ll each receive a K1 with $150,000 of taxable pass-through income, even though they only received $30,000 each.
S-Corporations: Ordinary Taxes and Capital Gains
An S-corporation is a business that has anywhere from 1 to 100 shareholders, meaning it can’t go public and needs formal registration with ownership percentages. Whereas a partnership can’t pay wages to the partners, S-Corps are required to pay owners with a W2 wage. This is typically based upon the average market rate of your expected pay from performing the duties of your role in the open market.
The amount of income paid via wage is treated similarly to any other employee, where a portion of the Medicare and FICA tax is covered by the employee and employer. The difference is the rest of the income that flows through to the business owner is taxed at ordinary rates. As a result, there’s no self-employment tax at the individual level.
One caveat to S-Corp taxes involves the handling of basis issues and debt-financed draws. If there are draws greater than the basis in the company (what the owner has contributed) then the difference of that amount will be taxed at capital gains rates. Essentially, there could be three different line items of taxes coming through on the owner’s return in this instance.
Jane and June are 50/50 shareholders and have been in business for five years. Every year they withdraw all profits from the company. The business made $60,000 in profit, and each of them took a wage of $100,000. They also each withdrew an additional $50,000 in distributions, and received $250,000 of PPP funding that was forgiven during the year. On their individual returns, they would report wages of $100,000, ordinary income of $30,000, and long-term capital gains of $50,000.
Limited Liability Companies: It Depends…
One of the best things about a business that’s set up as an LLC is its flexibility for tax purposes. An LLC can have one member (also known as a single-member LLC), or two or more members. The first default for an LLC’s taxation is based upon how many members there are.
As a single-member LLC, the default tax filing is to the individual return on Schedule C. There’s no separate tax return in this case, and all income would be taxed similar to a partnership: it’s all treated as self-employment income. As a multi-member LLC, the tax filing defaults to a partnership return. Again, all income would be subject to self-employment tax.
LLCs are very flexible because they can elect to be taxed as an S-corporation. We typically recommend a discussion about the benefits of electing S-corp status once your company has a net income of over $100,000. We use this as our guideline while providing recommendations because of the additional cost of filing payroll while also considering the potential for a separate tax return. Otherwise, the cost-benefit could potentially be nothing, but the hassle has increased.
The Bottom Line of Business Structures
Regardless of if they own a sole proprietorship, partnership, S-corporation, or LLC, business owners pay taxes on profits whether they received the funds or not. Taxes are complex and multifaceted. The necessary resources for a successful tax season are out there, sure. But compiling them, understanding them, and making informed, strategic decisions are an unnecessary burden on business owners. You have enough on your plate already from leading a business in this economy. Having tax experts in your corner that understand your circumstances while providing relevant advice on entity structures is crucial for business success. Reach out to our team and get started today. We’ll get to know you and provide real advice that always has your best interests in mind.