Legal Entities vs Tax Strategies

Many taxpayers confuse the idea of business structure and tax savings. Most are under the assumption that a legal entity such as an LLC creates tax deductions. This belief is far from the truth. A legal entity provides asset protection depending upon its entity type and what each state offers to protect your assets. A tax strategy is leveraging the tax code to the fullest extentregarding your circumstances. Legal entities create opportunities for tax strategies.

Below is a brief example of how legal entities create opportunities for tax strategies.

If a taxpayer has high-earned income with very little overhead, this taxpayer will be forking over more than 40% to 50% of their earnings to Uncle Sam. Rather than the taxpayer having his/her earnings reported as a sole proprietor without a legal structure and EIN, let’s suppose that a legal entity is formed with an assigned EIN from the IRS. Because of the formation of the legal structure, the taxpayer has opportunities to create additional tax savings through strategies. These strategies can range from the following:

  1. Making the S-Corporation Election reduces the amount of taxes paid into social security. 
  2. Depending on your activity, investing in real estate, solar, minerals, or gas/oil could create massive savings through tax credits, depreciation, and depletion.
  3. Investing in a family member’s business venture could offset passive losses against passive income. 

Depending upon the taxpayer’s unique tax matter and personal wealth goals, many strategies can be deployed to help reduce the tax burden. Here I provide each type of legal structure and examples of tax strategies that would work best. 

Sole Proprietors and General Partnerships

Let’s start with the Sole Proprietor and General Partnerships. These types of business setups are not necessarily viewed as business structures. The Sole Proprietor and General Partnership is more of a gateway into business structuring once you get your feet wet in the game of business (figure of speech). As a U.S. taxpayer, you do not need to formalize a legal entity to say that you are in business; all you have to do is register with your county that you would like to do business and either sell a product or offer a service. Pretty easy, right? Yes! 

Now that our business is set up, we can employ tax strategies.

Great strategies for sole proprietors and general partnerships are those that impact their everyday lives, such as:

  • Health Insurance—As a self-employed or general partnership, you are entitled to deductions for health insurance for yourself, your spouse, and your children.
  • Health Reimbursement Arrangements – As a self-employed business owner, you can hire your spouse solely to reimburse them for high out-of-pocket medical expenses.
  • Retirement Plans – as a self-employed or general partnership, you can set up retirement accounts and take a deduction to fund your account! Retirement savings is a huge tax savings for many business owners.
  • Hiring your children—As a self-employed business owner, you can employ your children under 18 and pay no employment taxes!

Limited Partnership

A limited partnership is one the most accessible forms of business structures to create as long asyou have more than one owner. As a limited partnership, you must have one general partner and one limited partner to activate this type of partnership. The limited partnership is created at the state level and, for tax purposes, is reported on your personal income tax return as a pass-through entity. 

Tax Strategies for the Limited Partnership (LP) impact the taxpayer’s wealth potential.

• Investing in Oil and Gas – Intangible drilling is a massive opportunity for taxpayers who qualify as accredited investors to help offset earnings with phantom expensing and tax-free cash flow.

• Investing in Energy Projects—Energy projects provide tax deductions and credits that can reduce your tax liability to nearly zero. 

• Family Management Partnerships (FLPs) are an excellent way for parents to control, protect (business and investment accounts), and transfer assets to their children through gifting strategies. The FLP creates a tax strategy for saving estate and gift taxes. 

Limited Liability Company 

Without being too technical, the Limited Liability Company, also known as the LLC, is an entity that protects its members from personal liability. The limited liability company is a hybrid of a corporation with a federal tax classification of a partnership, which allows members of the LLC to escape the double taxation rules in corporations. When creating your limited liability company, the organizer or governing persons complete this at the state level.  Next, you are to write your articles of organization to establish who the members and managing members are to be. The Limited Liability Company allows members to raise capital and limit their exposure to company risk by only purchasing their share of member interest.

Examples of tax strategies with the legal entity LLC are below:

  • S-Corporation election – having an active LLC is a pathway to reduce self-employment taxes and overfunding social security.
  • Investing in Residential and Commercial Real Estate – Real estate has huge tax benefits from accelerating depreciation and tax-free cash flow 
  • Self-Directing Retirement – The LLC structure allows you to move assets into an LLC and create your own Traditional or Roth IRA to grow your retirement. Self-directing is a long-term wealth strategy with tax-deferred or free income. 

In summary

Remember, a legal structure does not provide tax deductions nor allow you to escape taxation; however, employing tax strategies will reduce your tax burden overall.

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