At Emparion, we see a variety of different tax structures. Depending on the specifics, any entity structure can have a cash balance or defined benefit plan.
In this article, we will discuss the four main entity structures that we see. We will discuss then summarize each structure and discuss what is required to make sure you can contribute to a plan.
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S-Corporations
The vast majority of our plans are structured for S corporations. That’s because these corporations tend to be the most popular and tax-efficient business structure for successful small businesses.
You can set up an S corporation with an actual corporation or an LLC. Once one of these legal entities is established, you would file IRS Form 2553 to elect to be taxed as an S corporation.
So an LLC, or an actual corporation, can be taxed as an S corporation. But nowadays, it is usually easier and cheaper to set up an LLC. The tax structure is more flexible, so most plans we see are LLCs taxed as S corporations.
One of the reasons why S corporations are popular is because the income or net profits are not subject to employment taxes. Owners, who presumably work in the business, must pay themselves a W-2 that represents a “reasonable wage” for the work provided to the company. Only this wage is subject to employment taxes.
S corporations are also called pass-through entities. What this means is that they don’t pay taxes themselves. The net income or loss is passed through and included on the shareholder’s tax return.
So, for example, if an S corporation shows a profit of $100,000, it will not pay tax directly on the profit. The S corporation will issue a K-1 in the owner’s name, and that owner will include the $100,000 on their tax return and pay the associated applicable tax.
But when it comes to establishing a retirement plan, one crucial point exists. The S-Corp. owner/employee must pay themselves a W-2 to contribute to a plan. They can only fund a plan if they have a W-2. That’s because, in the eyes of the IRS, they are unemployed if a W2 is not issued.
Remember that plan contributions are generally calculated based on age and W-2 income. So, the higher the W-2, the more money they’ll be able to get into the plan.
Summary of critical aspects of S-Corporations:
- An LLC or an actual corporation may elect to be taxed as an S corporation.
- S-corporations are pass-through entities. They don’t pay tax directly as the tax is passed through to the owners.
- Owners who work in the business must have W-2s. These W-2s are required in order to make retirement plan contributions.
Sole proprietorship
The second most popular entity structure we see is a sole proprietorship. These structures are very easy to administer, but not the most tax efficient. They can work well for clients in the right situation.
With this structure, all you do is include the income and expenses of your business on Schedule C to your personal 1040 tax return. When you do that, the income will just get added to your other income on your tax return, and you’ll pay tax accordingly.
In addition to federal and state income tax, you’ll also pay Social Security and Medicare tax on the full amount of your Schedule C profit. As a result, they will often be subject to higher overall taxes compared to an S-Corporation.
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When you use a sole proprietorship, the full net income is allowable for retirement planning purposes. This is because the entire amount is subject to Social Security and Medicare tax.
In contrast to S corporations and C corporations, a sole proprietor will not issue the owner a wage on W-2. This is one of the reasons they are very simple and easy to administer.
Sole proprietors are typically used if you receive business income in your name or have an LLC taxed as a disregarded entity.
Here’s a summary of the critical aspects of sole proprietors
- They don’t file a separate tax return. The income and expenses are included on Schedule C and filed with the 1040 personal tax return.
- The entire net profit is subject to Social Security and Medicare employment taxes.
- Sole proprietors do not issue W-2s to the owners.
C-Corporations
C-corporations are similar to S-corporations, as owners who work in the business must receive W-2s based on reasonable compensation. This W-2 is used for retirement plan purposes.
But C-corporations have one significant difference. They are not pass-through entities. The owner will not include the profit from the C-corporation on their individual tax return.
The C-Corp. is a self-contained taxable entity. So, it pays its own income tax on profits and does not directly tie to the business owner.
However, C-corporations are subject to double taxation. They are taxed once on their profits and then again to the owner if (or when) a dividend is distributed from the C-corporation to the individual.
As a result of the double taxation, they are used sparingly with small businesses. They are typically used for larger companies with many shareholders.
But they can work out well for business owners who want fringe benefits. C-corporations can offer many types of fringe benefit plans relating to education, medical, and other benefits. If fringe benefits are something you are seeking, then a C-corporation could make a lot of sense for you.
Partnerships
The other entity that we see is the partnership entity. These companies file a partnership tax return using Form 1065.
A partnership is required when two or more owners go into business together. It is sort of like a Schedule C for two people.
Just like an S corporation, it is called a pass-through entity. The company’s profits are included on the individual partner’s tax returns.
But contrary to an S corporation, partners and partnerships are not issued W-2s. They do receive guaranteed payments, and generally, the profit from the company is subject to employment taxes assuming they work in the business.
The partnership issues schedule K-1 to each of the partners. There is a box on the K-1 that shows ordinary income. But more importantly, another box determines how much of that income is self-employment income. This critical box determines how much they can contribute to a plan. The partnership has to allocate self-employment income to the partners for them to be eligible for a retirement plan.
Here is a summary of the partnership taxation:
- A partnership is when two or more people enter into business together, and it is not classified as an S corporation or a C corporation. It can also be an LLC with more than one member.
- Like S corporations, partnerships are pass-through entities. But unlike S- corporations, partnerships do not issue W-2s to partners working in the business.
- In order to contribute to a retirement plan, the partnership has to identify income as self-employment income to the partner.
Final thoughts
Hopefully, you’ve learned a little about entity types and how they work with various retirement plans. Business owners must understand how they’re taxed and how this taxation impacts their retirement plans.
Ensure that your retirement goals are included in any decisions about entity structures.
