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Learn how pass through entities like LLCs and S Corps can help lower your tax burden and protect your business. Discover the benefits and steps to create one for your business.
Pass through entities, such as LLCs and corporations, have been gaining popularity among business owners due to their unique tax benefits and liability protection. In this blog post, we will explore the intricacies of pass through entities and provide you with a clear understanding of how they work, the advantages they offer, and the steps to create one for your business. So, if you own a pass through entity or are considering forming one, read on to discover how you can leverage these entities to lower your tax burden and protect your assets.The
Before delving into the details, let's start with the basics. A pass through entity is simply a business structure where the income generated by the entity "passes through" to the owners' personal tax returns. This means that the business itself does not pay income tax at the entity level. Instead, the owners report their share of the business's profit and losses on their individual tax returns. Pass through entities include entities like LLCs (limited liability companies) and S corporations.
One of the key benefits of choosing a pass-through entity is the potential tax savings. Unlike other corporations, pass through entities allow owners to potentially pay a lower tax rate on their share of the profits. This can result in significant tax savings, enabling business owners to retain more of their hard-earned money.
Furthermore, pass through entities provide personal liability protection for the owners. In the case of an LLC, the owners, also known as members, are generally not personally liable for the debts and obligations of the business. This means that the personal assets of the owners, such as their homes and cars, are protected from business-related lawsuits and financial issues to a certain extent.
If you're interested in forming a pass through entity for your business, here are the essential steps:
1. Choose a Name: Select a name for your entity that complies with your state's rules and regulations.
2. File Necessary Paperwork: File the required paperwork, such as "articles of organization" for an LLC or a "certificate of formation" for an S corporation, with your state secretary of state office. Pay the necessary filing fees.
3. Create an Operating Agreement: Draft an operating agreement that outlines the ownership structure, management responsibilities, and other important details of your business. It is crucial to consult with a qualified attorney or business advisor during this step to ensure compliance with all legal requirements.
Pass through entities offer several tax benefits that can contribute to significant savings for business owners. One of the primary advantages is the avoidance of double taxation. Unlike corporations, where income is taxed at both the entity level and individual level, pass through entities only pay tax at the individual level. This means that owners can potentially save on taxes by avoiding additional corporate tax.
Additionally, pass-through entities, such as S corporations, offer the opportunity to pay yourself a reasonable salary and receive the remaining profit as distributions. By doing this, business owners can reduce the amount of self-employment tax they have to pay, resulting in substantial tax savings. However, it is vital to consult with a professional to ensure proper setup and compliance with tax regulations to avoid mistakes that can potentially lead to penalties.
Pass through entities also provide flexibility in retaining earnings within the entity for various purposes, such as reinvestment, expansion, or debt repayment. Unlike corporations, there are typically no specific restrictions or accumulated earnings tax imposed on retained earnings in pass-through entities. However, it is essential to consult with a tax professional to ensure compliance with relevant tax laws and regulations.
While retaining earnings can have its advantages, it's important to consider the tax implications. Even if the earnings are retained within the pass-through entity, owners may still be required to pay taxes on their share of the profits. This is because these retained earnings are generally considered "phantom income" or "constructive dividends" and are reportable on the owner's individual tax return, regardless of whether the earnings were actually distributed. It's crucial to consult with a licensed accountant who can provide personalized guidance based on your specific circumstances and the most recent tax regulations.
Conclusion:
Understanding pass-through entities, such as LLCs and corporations, is vital for business owners looking to optimize their tax strategy and protect their assets. These entities offer unique tax benefits, personal liability protection, and flexibility in retaining earnings. By navigating the intricacies of pass through entities, you can lower your tax burden, safeguard your personal assets, and set your business up for financial success. Remember to consult with qualified professionals to ensure compliance and maximize the advantages that pass through entities can provide for your specific situation.
We hope this comprehensive guide has provided valuable insights into pass through entities. If you have any questions or topics you'd like us to cover in future episodes, feel free to leave us a voicemail message or visit our podcast page at askralphpodcast.com. Stay financially savvy and make the most out of your pass-through entity!
Note: The information provided in this blog post is for general informational purposes only and should not be considered as legal, financial, or tax advice. It is always recommended to consult with qualified professionals before making any business or financial decisions.
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EP 33 - Pass Through Entities Explained
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Let's start with a question today. Do you own a pass through entity like an LLC or S Corp? And you're trying to figure out how to keep money in your business. Without having it taxed. This is the very question from one of our listeners. And we're going to answer that great question today.
Welcome back to the ask Ralph podcast. Where we explore strategies for mastering your finances. Lowering your taxes, growing your business, and finding personal success. I'm your host, Ralph Estep, Jr.. And in today's episode, we'll be diving into the fascinating world of pass through entities. Specifically LLCs and corporations.
Today, we're going to uncover how these entities work, the tax benefits they offer, and how you can create one for your business. Stay tuned, my friends, because by the end of this episode, you'll have a clear understanding of how to leverage these entities to your advantage and protect yourself from potential liabilities. But first. Let me ask you another question. Do you want to lower your [00:01:00] tax burden and grow your business? If the answer is yes, then this episode is for you.
So, let's get started.
Well, before we delve into the intricacies of pass through entities, let's take a moment to understand just what we're talking about. A pass through entity is not that complicated. It's simply a business structure where the income generated by the entity "passes through" to the owners, personal tax returns. This means that the business itself does not pay income tax. At the entity or business level. Instead. [00:02:00] The owners report their share of the business's profit and losses on their individual tax returns. It's important to know that pass your entities include entities like LLCs. Which are (limited liability companies) and S corporations.
If you use these, you're basically going to file two tax returns. You're going to have a business tax return and a personal tax return. So you might be wondering. Ralph.
Why would someone choose a pass-through entity over another business structure? One of the key benefits is the potential tax savings. Because the income is not taxed at the entity level, owners of pass through entities could potentially pay a lower tax rate. On their share of the profits. Compared to other corporations. This can result in significant tax savings. Allowing business owners to retain more of their hard earned money.
And in the end, isn't that what we're all trying to accomplish.
So, the next logical question, ralph. How do we create a pass through entity for my business?
Well, let me break it down. for you. [00:03:00] Let's say you're interested in forming an LLC.
The first step is to choose a name for your LLC. This name needs to comply with your state's rules and regulations. Next, you'll need to file the necessary paperwork with your state secretary of state office. This typically involves submitting articles of organization. Or in Delaware, they call it a certificate of formation. And paying a filing fee. Once your LLC is officially formed.
You'll need to create an operating agreement. Which outlines the ownership structure. The management responsibilities, and other important details of your business. This is the point where it's crucial, you consult with a qualified attorney or business advisor that handles these type of situations. To ensure that you're following all the legal requirements and setting up the LLC correctly.
The truth is I've seen so many of these entities, which were created wrong. And resulted in huge issues for the business owners. So it's really vital to consult with an expert before [00:04:00] creating an entity. .
You know, you can go online and you can find ads all over the internet claiming you can create your entity for just $99. But I think I've said this before. I say this to people all the time. You get what you pay for?
And it's important that you start with a strong foundation.
So now, let's explore the potential liability benefits of using a pass through entity.
One of the main advantages is that it can offer personal liability protection for the owners. In the case of an LLC, the owners, also known as members. That's the fancy name for owners of an LLC. Are generally not personally liable for the debts and obligations of the business.
This means that if the business faces a lawsuit or financial issues, The personal assets of the owners. Such as their homes, cars. And other personal assets are generally protected.
However, it's important to note that this liability protection is not absolute.
And my friends, what in life is absolute. And there are certain circumstances where [00:05:00] owners can still be held personally liable. Such as if they personally guarantee a loan. Or engage in fraudulent activities. or in my opinion, do anything that's personally negligent that you should have not done.
I am not an attorney and I offer no legal advice to listeners. Consulting with a legal professional is absolutely essential. To understand the specific laws and regulations in your local jurisdiction.
So now that we've covered the basics of pass through entities.
Let's dive into the tax benefits they offer.
One significant advantage is that pass through entities, allow for the avoidance of double taxation. If you know anything about corporations you've may have heard this term, double taxation. Unlike corporations, where income is tax at both the entity level. In other words, the corporation pays taxes. And the individual level when dividends are distributed, or salary has paid. Pass through entities only pay tax at the individual level.
So you just pay the tax at your personal income tax return level. [00:06:00] This means that the owners can potentially save on taxes by avoiding the additional corporate tax. In addition. Certain pass through entity, such as S corporations. Offer the opportunity to pay yourself a reasonable salary. And receive the remaining profit as distributions.
This can result in potential tax savings by reducing the amount of self-employment tax that you have to pay. This can result in a huge tax saving. If it's set up correctly and you take the required reasonable salary. Unfortunately, I've seen this setup all wrong. As I discussed before, where corporations are not taking that reasonable salary or it was way too low.
So it's absolutely critical. You consult with a professional.
Another tax benefit of using pass-through entities is the ability to deduct business losses on your personal tax return.
If you're pass through entity incurs a loss. You can generally deduct that loss against your other sources of income. Such as salary or investment income. [00:07:00] This can truly help offset your overall tax liability and could lead you into the ability to get a refund.
However, again. It's important to consult with a tax professional to ensure you're following all the rules and limitations. When it comes to deducting business losses.
So let's answer the question posed about keeping money in the pass, through business.
Here are some key considerations.
Let's first start talking about taxation of profits. As we talked about a few minutes ago. Pass-through entities do not pay income tax at the entity level. Instead, the profits and losses "pass through" to the owners or shareholders. And are reported on their individual tax return. This means that retained earnings are not taxed at the entity level. But are allocated to the owners. Who are then responsible for paying taxes on their share of the earnings.
The next thing we need to discuss is distribution of profits. The owners of a pass through entity can choose the distribute portion or all of their earnings to themselves. These distributions are [00:08:00] typically reported as taxable income to the owner. But they're not subject to self-employment tax.
And that really is the whole deal here. You set up an S-corporation and you take. A reasonable salary. Only on that reasonable salary. Are you paying that self-employment tax? On the other income from the business, you're going to pay federal and state tax. When it, depending upon where you live. But your sheltering, you from that self-employment tax. The ability to distribute profits depends on the internal agreement or operating agreement in LLC. And any legal restrictions or requirements imposed by relevant authorities.
So it leads us to the question that was asked about retained earnings. Pass through entities may also choose to retain earnings within the entity for various purposes.
That could be. Re-investment, expansion, or debt repayment.
Unlike corporations, there are typically no specific restrictions or accumulated earnings tax that apply to retain earnings in pass-through entities. However, it's essential to consult with a tax professional to ensure [00:09:00] compliance with any applicable tax laws and regulations.
Which leads us to the real answer. And that's the tax implications. And this is where having a pass through entity. And retain earnings. Doesn't always sync. Even if earnings are retained within the pass-through entity. The owners may still be required to pay taxes on their share of the profits.
This is because the earnings are generally considered "Phantom income" or "constructive dividends" and are reportable on the owner's individual tax return. Regardless of whether the earnings were actually distributed. Thus, owners may face a tax liability, even if no actual cash distribution occurred. So let's talk about that in real life. It's a conversation I have with my clients. Let's say you set up an S-corporation for yourself.
So you have a dog walking business and you're going to set up an S-corporation. So you decide I'm going to do what Ralph said. I'm going to take a reasonable salary. So let's say that your business had gross sales of a hundred thousand dollars. That's our [00:10:00] starting point. Then you took a $50,000 salary from the business. So your net income after your salary and other expenses, $50,000.
So then you've already taken 50,000 as salary.
The remaining $50,000 will come over to your personal tax return. Without being subjected to self-employment tax now. That's the tax side of that.
Regardless of whether you take the money out of the business or leave it in, you're still gonna pay tax on whatever the total net income was. On the return. So in our example, we said we started a hundred thousand dollars. We had a net profit of 50. So, whether you take the 50,000 out. Or leave to 50,000 in. You're still going to pay tax on that. So that's the whole point, right? That's a discussion you have to have. It's worth noting that pass through entity. Taxation rules can be complex as you can see, and subject to change. It's advisable to consult with a licensed accountant who can provide personalized [00:11:00] guidance based on your specific circumstances and the most recent tax regulations.
And I know we've covered a lot today. And we got a little bit in the weeds. But I hope this has been helpful to you.
So as we conclude this episode, I want to remind you to visit our podcastPage@askralphpodcast.com. There, you can leave a review, share your thoughts, or you can even send us a cool voicemail message by clicking on the microphone icon. Leave us any questions or topics you'd like us to cover in future episodes. We absolutely love to hear from our listeners.
Just like we heard from this listener. And we value your feedback.
Well, thank you for joining me today on the Ask Ralph podcast, we're exploring the ins and outs of pass through entities, such as LLCs and corporations. We discussed how these entities work. The tax benefits they offer, and the steps to create one for your business. By understanding and leveraging these entities, you can absolutely lower your tax burden. You can protect yourself from liabilities. And set yourself up for financial [00:12:00] success.
And I leave you with this. Remember, mastering your finances, lowering your taxes, growing your business, and finding personal success is a journey. Stay tuned for more episodes of the ask Ralph podcast, where we continue to provide valuable insights and strategies. To help you on your path to financial freedom. So until next time, thank you for listening. God bless, and as are always say, stay financially savvy.
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