Even though sole proprietorships are the most common business entity, most builders operate through a separate business entity for legal liability purposes.
The business entity decision should be made in consultation with the owner’s lawyer as it impacts potential legal liability related to business operations. That choice also has significant tax implications.
A new Medicare surtax on employment income and a new tax on net investment income were enacted as part of The Health Care and Education Reconciliation Act of 2010, with a delayed effective date of Jan. 1, 2013.
A sole proprietorship is a business operated directly by the owner, without a separate legal entity between the owner and the operations.
A sole owner of a business, however, often operates as a single member limited liability company (SMLLC). It is a separate legal entity but is disregarded for tax purposes. Any business profit or loss is reported directly on the owner’s individual income tax return. Business profits are subject to both income tax and self-employment tax, the equivalent of Social Security and Medicare taxes imposed on employers and employees.
When a business partner is included in the ownership group, the business entity of choice is often a multi-member limited liability company (LLC). Business profits are split among the owners and are subject to both income tax and self-employment tax.
Unlike an SMLLC or an LLC, owners of an S corp may have dual status with the company – they may be both owners and employees.
With S corporations, business profits and employment income are both subject to income tax, but only the employment income is subject to Social Security and Medicare taxes. This may result in saving 2.9 percent in Medicare taxes on the business profit not included in employment income, as well as the new 0.9 percent Medicare surtax imposed on employees and self-employed taxpayers.
That new 0.9 percent tax is part of new healthcare taxes on employment income over $200,000 on a single return or $250,000 on a joint return.
An S corp may be preferable to an SMLLC or an LLC from a tax perspective when significant leverage has been introduced into the business by hiring employees in the operation. In that case, the business profits may not be generated solely by the personal services of the owners but also by the services rendered by employees.
When S corporation shareholders are compensated for their personal services with a reasonable salary, the excess business profits will not be subject to either the 2.9 percent Medicare tax on 2013 earnings over $113,700 or the 0.9 percent surtax. To prevent avoidance of the Medicare taxes, the IRS maintains that S corporations must pay reasonable compensation to an owner-employee in return for services that the owner-employee provides to the corporation before business profits may be distributed.
Some factors the IRS uses in determining reasonable compensation are:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and payment of bonuses to key people
- Payment for services by comparable businesses
- Compensation agreements
- Formula to determine compensation
In addition to the Medicare surtax on employment income, a 3.8 percent tax on net investment income applies to interest, dividends, capital gains and other passive income. In the case of a trade or business, the tax applies to business income if the trade or business is a passive activity with respect to the taxpayer, but does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.
Builders often hold and manage real estate, which generally is a passive activity. While many builders may qualify for an exception from the passive activity rules for real estate professionals, review and documentation of that status is important to avoid the new 3.8 percent healthcare tax that could be imposed.
Careful tax planning and documentation may minimize both the new 0.9 percent surtax, when business profits are received in addition to a reasonable S corporation salary, and the new 3.8 percent tax, when income is derived from an active rather than passive business.