Demarest: How to Stop Overpaying Taxes Without Finding More Deductions

While most people are concerned about getting every last deduction and making sure that they don’t pay taxes on money they won’t receive, few business owners think that how they file their taxes could have even more impact than what they file. It’s not a sales pitch. Focusing on something that could give you a $100 deduction and ignoring that filing a tax return without proper consideration of entity choices could be costing you 10 times as much.

If you are short on time, the best way for most shops to be taxed is organized as an LLC and taxed as an S-Corporation. The longer story is depending on how much you make, how many owners you have, and what you plan to do with the business is going to change the answer. This is not meant to be a replacement of your accountant in making the proper decisions, but hopefully it can get you to start asking the right questions with your accountant to make an informed decision.

Consider the Options

Before we get too far into how we’re going to elect to be taxed, we need to figure out how to organize your business. Confusing your entity type with your tax status is one of the most common confusions: are you an S-Corp or are you an LLC? Chances are you are both.

When you set up your business as a legal entity you have three real choices:

1. A corporation (Inc.) 
2. Limited liability company (LLC)
3. Run by yourself (sole proprietor).

Ranking from most common to least common in today’s market, LLC is by far the favorite choice for most people. It is set up on the state level but federally recognized, gives good legal protection, it’s easy to set up, and has the most choices of taxation of any of the choices. The second most common would be a sole proprietor; this is just you doing business and you might not even know that this is happening. The most common example is if you own your commercial building personally and rent it to your business, you are a sole proprietor. The least common example is an entity structured as a corporation. While in some situations it could make sense, it is generally considered overkill for small businesses.

So, which one should you choose? Do you want personal legal protection separate from your business? Do you want choices on tax returns that you file? Do you want to separate your personal name from the business? Do you want more protection from creditors and lawsuits? If you answered yes to any of these, you need to be an LLC. In reality, almost any entity that has income and liability should have an LLC because if you don’t have a separate legal entity, you are the legal entity, and everything you have could be at risk.

Ask the Right Questions

Once you’ve elected to be an LLC, you’ll need to decide on how to elect the IRS to treat you. This is a very important statement that I don’t want to gloss over: you actually get to tell the IRS how you want to be taxed. This is a shock for most people and if it’s a shock to you, I hope that it’s not a shock to your accountant. Although it’s rare, we do see at least one case a year in which we review tax returns that someone else has prepared and see this very mistake. The last client that we reviewed, we estimated he overpaid over $100,000 in taxes in the last 10 years just by not electing to be taxed correctly, so don’t let this happen to you.

As previously mentioned, how you elect your LLC to be taxed depends on what you are doing with the business, how many people own it, and how much you are making. These three factors should help to narrow down the right entity choice for just about any kind of auto repair or related business.

The first factor to think about is what you’re doing. If this entity is your auto repair shop, I’m going to have a different answer than if it is a passive real estate investment company. If the business is active, there are additional tax considerations to think about, such as payroll taxes, self-employment taxes, and one of the main reasons that shops go to an S-Corp status is to avoid high self-employment and payroll taxes. However, for a business like rental real estate or any other passive businesses, few of these opt for an S-Corp. The reason that you go to an S-Corp is to save money on taxes, but if you aren’t going to save any money on taxes, then why file an additional return? Remember, the LLC gave you legal protection; any choices beyond that don’t increase or decrease your legal protection; therefore, if it’s not broken don’t fix it.

The next part of this is combined with the number of owners in the company and how much you make in the business. This also compounds with the previous comments about the nature of business. Generally, it goes in that order: the nature of the business dictates the initial election, and then income and ownership possibly change that in the future. If you have a passive real estate investment with two owners, you are going to have to file a partnership return but will still be taxed at the same rate as if you had one owner. However, if you are a shop with one owner, there is a different level that makes sense to switch to an S-Corp than an LLC with two owners. The overall idea here is that if you are an LLC and have not made an election to be taxed as an S-Corp, all of your income is taxed as if you ran it through payroll. More or less, a 15% premium (self-employment tax) is added to your taxes to account for the lack of payroll and payroll taxes throughout the year. When you go to an S-Corp, you have to pay yourself wages, but income over that is not subject to any premium, which is where the planning lies. An LLC/sole proprietor who makes $140,000 would save roughly $10,000 by going to an S-Corp because while the business made $140,000, he would have half of that on payroll, subject to payroll taxes, but the remaining $70,000 of profit would save about $10,000 in payroll taxes. On the other hand, if there were two owners being taxed as a partnership (a two-member LLC is automatically a partnership), they would have the same issue but wouldn’t have any tax savings by going to an S-Corp. Why? The owners would both have to go on payroll, leaving the same net effect. If you are over that amount, you will save money by going to an S-Corp, but if you are under that, it will cost you money.

At the end of the day, you should truly care how you are organized. Although an LLC is the most common choice, you shouldn’t care how you are taxed as long as it’s the most advantageous way possible. Does this mean that you need to switch this year? Maybe. Does this mean that you could have choices to make for this upcoming year? Maybe. Is this something that should be done periodically and not a one-time decision? Absolutely.