If you own a farm, you have a decision to make.
Which legal entity will you use for the property? You can use a sole proprietorship, partnership, LLC, S corporation, or C corporation. While your decision involves more than tax consequences, that’s what we’ll focus on here.
What if I told you that you can choose not to pay personal income tax for a period of time? You might have heard a few years ago that Warren Buffett, president of Berkshire Hathaway, paid a lower income tax rate than his secretary. In fact, billionaires couldn’t pay any personal income tax.
This is how it’s done. Let’s say you own a C farming corporation with $ 1 million per year in profits. As the CEO and major shareholder, you can choose to pay yourself $ 1 per month in salary and you could convince the board of directors (you) not to pay any dividends from the company. Therefore, your personal taxable income from the corporation is $ 12 per year. If you and your spouse earn less than $ 25,000 a year in interest, dividends, pensions, or other income, you will not owe any federal income tax.
Company C farms
Who pays tax on the million dollars in profit? The company does so and currently at a maximum federal rate of 21%. (Corporate and personal tax rates could go up next year.) Why isn’t everyone using Company C? The answer is double taxation.
Most people need cash to live. When they pay themselves dividends from their C corporation, they owe tax on those dividends. Dividends are not deductible for the company, so the company also pays income tax on the income that enabled those dividends. This equates to 15, 20, or even 23.8% federal dividend tax at the individual level, plus up to 21% federal tax at the corporate level.
So if you’re paying yourself C corporation dividends for your living expenses, you’re probably going to pay as much or more in taxes than you would pay for running an S corporation, which we’ll talk about later.
How could you live for a while without income from your C corporation? You will likely need to set aside at least a few hundred thousand dollars for personal expenses that the business does not. You can keep this in a low interest savings account. This is the scenario of company C.
S Corp Farms
A subchapter S corporation pays no income tax. The owners pay tax on all profits made within the S corporation, and they pay it on their individual tax returns. Logistically, this happens through a Schedule K-1, the IRS form that an S corporation uses to transfer information about profits, interest, capital gains, and distributions to its tax records. owners.
Since personal tax rates start at 10%, many small business owners use S corporations to operate. They benefit from the graduated federal personal income tax brackets of 10% to 37%. The 35% tax bracket ends at $ 628,300 for 2021. This is where the top rate of 37% begins.
A huge point of confusion that I explain to some clients every year is with distributions outside of S corporations. People assume that if they don’t distribute money to each other, they don’t pay taxes on it. However, this is not how it works for an S corporation. The owner pays tax on the profits made by the corporation whether or not the money is distributed outside the corporation.
You can earn $ 1 million in your S corporation and distribute $ 0, $ 500,000, or whatever amount up to $ 1 million, and you owe tax on $ 1 million. You might even distribute over $ 1 million in any given year because you had already taxed undistributed income from previous years.
Another caveat with S corporations is that the IRS wants you to pay yourself a reasonable salary for the duties you perform. This is a question for you and your CPA to think about, but anything you pay yourself in wages will be affected by Social Security and Medicare taxes. They total 15.3% on the first $ 142,800, taking into account both the share of the employer and the share of the employees. This can represent a large sum of money, depending on the amount of the salary. This question is the main tax difference between running an S corporation and running a partnership.
Farms in partnership
For a partnership, the partners personally pay the tax on the profits made by the partnership, just like an S corporation. However, by default, all profits made by an active partnership are subject to self-employment tax or taxes. social security and health insurance taxes under another name. An S corporation owner pays Social Security and Medicare on wages but not on profits. However, the owner of the partnership cannot receive a salary and therefore pays self-employment tax on all available profits. Why can’t a partnership owner receive a salary? It’s just an IRS rule.
Because of this tax disadvantage of self-employment, we rarely see active small businesses operating in partnership. Note that passive income generated by the partnership is not subject to self-employment tax. As a result, we see many rental property owner partnerships. Also, if you and your partners are going to lose money on an active farm, there is nothing wrong with managing it through a partnership for tax purposes. Some tax experts will say this is preferable, given the complex basic limitation rules for S corporations.
If you operate a farm yourself and do nothing with legal entities, you are automatically a sole proprietor for tax purposes. Active sole owner farmers use Schedule F to report their taxable income or loss. Being taxed as a Schedule F is similar to being taxed as a partnership, but there is only one partner. All profits are subject to personal income tax and self-employment tax. When your profit is very low or negative, Schedule F is a good alternative. If your taxable profit is over $ 50,000 per year, I think you should consider other entities.
A passive sole proprietor farmer can be considered a farm owner. The farm owner reports his income on Form 4835, which is similar to Schedule E that others might use to report rental income. This is a better way to get taxed than Schedule F as there is no self-employment tax on profits. For you, being “passive” basically means that someone else plants, harvests and milks the cows. You only receive a share of the harvest or a cash rent.
The limited liability company, or LLC, is essentially an empty box for tax purposes. This is a state authorized layer of liability protection. The One-Member LLC is Sole Proprietorship by default, which means a Schedule F or Form 4835 for a farmer. The Multi-Member LLC is a partnership by default. A one or more member LLC can elect with the IRS to be taxed as an S corporation.
There are more considerations than just taxes in determining your ownership structure, so consult with a CPA and lawyer.