Tax Company Trying To Convince Me To Join Them?

[KingHippo]

One of the bonuses I got when forming my LLC online was a free consultation with a tax specialty corporation. The guy basically told me that it was dumb for me to be taxed as a sole proprietorship (I have a single member LLC, no employees) and that I should become taxed as a corporation.

I'm not sure if this guy was just pushing for a quick sale or if his tax business could seriously save me a lot of money. Basically he was saying if I made $40,000 for the business, after taxes I would only get around $23,000 unless I signed up for his tax services and got switched to a corporation.

He told me that I couldn't just take my business taxes to H&R Block. I thought all I had to do was file a Schedule C along with my 1040? Do you guys think that for a small online software business that I should be taxed as a corporation?

[Evan]

H&R Block offers tax services for businesses as well -- though they are a rip.

Most companies would NEVER benefit being taxed as a corporation, at least under the traditional scheme. Electing subchapter S status is more advantageous, but that isn't right for every business either.

With $40,000 as net income, your tax liability would be much less than this guy estimates. Take a look:

$40,000
x 15.3%
-------------
$6,120 Self-Employment Tax (Half of which you get as a deduction -- $3,060).

Your income tax liability would be (assuming single, and only claiming yourself as an exemption, not over 65 and/or blind):
$40,000
- 3,060 [One-half of self-employment tax]
-----------
$36,940
- 3,500 [2008 personal exemption]
- 5,450 [2008 standard deduction]
-----------
$27,990 [15% Tax Bracket]
- 8,025 [Highest wage in the 10% bracket]
----------
$19,965
x 15%
-----------
$2,995 + $802.50 [Max tax in 10% bracket] = $3,798 [Total Income Tax]

Total Tax Liability = $3,798 + $6,120 = $9,918

If you're married or have dependents, this number would be different. But it gives you a rough idea of what your tax liability would be from the business itself. Add in interest from bank accounts, capital gains or losses, or credits you may be eligible for, of course your real tax liability may be different.

If this was a corporation, you'd be paying probably 15%-25% corporate income tax, plus you'd be required to pay yourself a salary. You'd certainly save yourself in the "self-employment tax" arena. The payroll taxes are essentially "self-employment taxes", but your savings would probably not be that considerable. Plus as a C-Corporation, if you decide to issue dividends (in lieu of a salary, which the IRS prefers for a C-Corp), you'll be paying that 25% on income [you get no deduction for dividends], plus paying personal income tax as well.

With an S-Corp, you'd prevent the issue with dividends, but then you have to worry about paying yourself enough with payroll. Factoring in the cost of payroll, I don't think at $40K that an S-Corp would be worth the aggravation.

Sit down with this guy and have him break down his numbers. I'd be interested in where he's getting this information from.

[Business Attorney]

I agree with everything that Evan said. I thought it might be interesting to illustrate one of the exceptions to the rule that most companies would not benefit from being taxed as a corporation. The following example is probably NOT your situation (or even close) but is simply for people who like to ask "what if..."

Say that I am in the highest individual tax bracket already. With Federal income and Medicare tax, let's say that is a 41% rate. (I will assume state taxes are zero.) On $40,000 business income reported as a sole proprietor, that would be $16,400, leaving me with $23,600.

Now let's say that the business is a C corporation and is not a personal service corporation and that I do not draw a salary from the business. Perhaps it is a sandwich shop and all I do is hire a manager and balance the checkbook. I leave the money in the company, either to pay down debt or to build up for future uses.

The corporate tax rate is graduated, and is 15% on the first $50,000. My company's $40,000 income is reduced to $34,000 after paying the corporate income tax ($40,000 x .15 = $6,000). That leaves me over $10,000 more to invest than if I had paid taxes at the individual rate.

Now remember that, when paid out as dividends, that remaining income is subject to a double tax. Depending upon what your situation is, however, you may never pay a double tax. If you sell the stock of the corporation, the amount you left in will increase your gain (presumably long term capital gain), so while the amount is taxed a second time, the combination of the the corporate tax and the capital gain tax may still be less than the individual tax.

Alternatively, you may be able to justify paying both the retained earnings and the growth on those earnings as salary in a later year. That will be deductible to corporation (potentially wiping out the prior taxes and generating a tax refund) and will be taxed to you. Perhaps by then you will have retired and be in a lower bracket or perhaps you simply benefit by having invested the extra $10,000 for a few years.

I also want to point out that this scenario only works for small corporations. The low marginal rate is "recaptured" as the corporation's income grows above $100,000 in a given year.

I doubt that even one in a thousand small businesses could benefit as illustrated in this example, but if you have the right situation, you may find that the tax rates on a C corporation can save you a few bucks.

[Evan]

I doubt that even one in a thousand small businesses could benefit as illustrated in this example, but if you have the right situation, you may find that the tax rates on a C corporation can save you a few bucks.

Me either, but the example certainly makes sense. For most people the C corporation won't benefit them, but each persons tax situation is difference. Lots of things can complicate it -- unfortunately!

Your situation assumes the following:


You're under the the highest personal income tax bracket because of your spouses income, a high paying full-time job, winning the lottery, etc.
Your businesses net income never exceeds $75,000 where the tax rate jumps up from 25% to 34%-39% depending how much over $75K. OR that the company isn't defined as a PSC, which would then provide the corporation a flat tax of 35%

Then, above that, your going to assume that they know the ins and out of the tax system :-P

[orion_joel]

Oh my the Australian system sounds so much simpler after reading this. I wont throw details in to confuse things but basically tiered personal rates flat corporation rate, if you earn enough to be in highest personal bracket you are immediately better off with a corporation. Of course different industries and such have differences but for the most part of a standard run of the mill business that is it (Plus sales tax of course). But that is Australia so not really applicable here.

[Evan]

The intent of the progressive tax system is to put a higher tax burden on those making more money. But even if you have income in a 35% tax bracket, your first X dollars are taxed at Y%, the next Z dollars are taxed at A%, etc. Your effective tax rate is usually not a flat number.

This is the system we have, love it or hate it :P