Income Tax

Boo to that!

Jane and I met with a lawyer yesterday, and we verified that a Limited Liability Company (LLC) is going to be the best way to structure our business. Before we apply for a Federal Employee ID Number, we'll have to decide if we want our company taxed as a corporation or a partnership for income purposes. Being taxed as an S-corporation would be more attractive than a C-corporation, and I believe we can elect to be taxed as either. I might not be right, but here's my interpretation of the situation:

Suppose that Jane and I each own 25% of the company and pay ourselves $40,000/yr salaries. After paying ourselves, assume that our 2009 profits will be $20,000 and that we'll put $4,000 of it in our company reserve. If we have 10 investors who all contribute the same amount of startup capital, each of them would own 5% of the business and receive $800 of the remaining $16,000. Finally, assume that 2006 tax rates are in effect.

If taxed as a C-corporation:
-The total $20,000 income will be taxed at the corporate rate of 15%, which means that the government would take $3,000. As a result, our investors would have $13,000 to divide between them instead of $16,000.
-Jane and I would each pay a 15.3% self-employment tax on our salaries, and then pay personal income taxes on what's left.
-Each investor would pay personal income taxes for their $650 dividend. If an investor is taxed at 25%, their take-home pay would be $487.50.
-Jane and I would also owe personal income taxes on our dividends.

If taxed as an S-corporation:
-Only the $4,000 in retained earnings would be taxed at the corporate level, which would result in the company owing $600 in income taxes.
-Jane and I would each pay a 15.3% self-employment tax on our salaries, and then pay personal income taxes on what's left.
-Each investor would pay personal income taxes for their $800 dividend. If an investor is taxed at 25%, their take-home pay would be $600.
-Jane and I would also owe personal income taxes on our dividends.

If taxed as a partnership (the LLC default):
-The company doesn't pay income tax.
-Jane and I would each pay a 15.3% self-employment tax on our salaries, and then pay personal income taxes on what's left.
-Taxes on investor income are based on percentages of company income, not paid dividends. This means that earnings retained by the company are still considered investor income, and each investor would "make" $1,000 even though they would only be paid $800.
-Each investor would pay a 15.3% self-employment tax on their $1,000 income, which would be $153. Each investor would then pay personal income taxes for their remaining income of $847. If an investor is taxed at 25%, their take-home pay would be $435.25.
-Jane and I would also owe personal income taxes on our share of company income.

Under a partnership tax structure, it would be possible for the company to reinvest enough money that investors would owe more in taxes than they would earn in dividends. Ugh! I know that incorporating the business as an S-corporation would result in more paperwork than would be worthwhile, but I'm not sure about having an LLC that's taxed like an S-corporation. Jane is gonna talk with someone tonight who knows a thing or two about taxes.