Business Magazine

Law in the Marketplace: Taxation — Sole proprietorships vs. single-member LLCs

Law in the Marketplace: Taxation — Sole proprietorships vs. single-member LLCs

Many thousands of New Hampshire individuals who own single-owner businesses conduct their businesses as sole proprietorships; that is, they don’t use LLCs or other state-law entities to conduct them. All of these individuals owe it to themselves to consider whether, for legal or tax reasons, they should conduct them instead as single-member LLCs. In last week’s column I outlined the relevant legal factors. This week, I’ll outline the main federal and New Hampshire tax factors. For concreteness, I’ll talk about these factors insofar as relevant to a hypothetical New Hampshire business owner named Mary Jones.

Principal federal tax factors

The default federal tax regimen. Like most other sole proprietors, Mary accepts the default federal regimen of sole proprietorship federal taxation and, like most of them, she reports her federal income, expenses and other tax items on Schedule C of her Form 1040. However, if her business is farming and in certain other situations, she may have to use other IRS schedules.

The Section 199A 20% annual federal income tax deduction. A key federal tax goal for Mary should be to maximize the annual federal income tax deduction available to her under Internal Revenue Code Section 199A. If Mary’s taxable income is at or under her Section 199A “threshold amount,” sole proprietor taxation will be fine for her. However, if her taxable income exceeds her Section 199A threshold amount, she should probably be taxable as an S corporation. For 2022, the Section 199A threshold amount for individuals filing joint returns is $340,000; if they file separately, it is $170,000.

However, under the applicable IRS rules, if she conducts her business as a sole proprietor, she can’t make an S election; she can only do so if she converts her sole proprietorship to a single-member LLC.

Avoiding Social Security Taxes under the “Prop. Reg.” Under a little-known but powerful proposed IRS regulation designated Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”), Mary can lawfully realize very substantial Social Security Tax savings. However, under the Prop. Reg., she can do so only if she conducts her business as a multi-member LLC taxable as a partnership. Thus, if she wants the above Social Security Tax savings, she will need to convert her sole proprietorship to an LLC and admit a second member to it. Spouses are often ideal second members for this purpose.

Avoiding Social Security Taxes as a single-member LLC. If Mary conducts her business as a sole proprietorship, all of her net business income will be subject to federal sole proprietorship taxation. However, in this situation, too, if she converts her business to a single-member LLC and make an S election, she may be able to pay herself a relatively low salary, and her net business income will not be subject to Social Security Taxes.

New Hampshire state tax factors

The “BPT.” If Mary’s gross income is $92,000 or less, she will not be subject to the annual New Hampshire Business Profits Tax (the “BPT”) for 2022 and later years. The BPT will apply at a rate of 7.6% of her net business income. However, if Mary’s income is about that threshold, she can avoid the BPT to the extent that she treats her business income as compensation. And she may not be required to treat as compensation for federal income tax the business income that she treats as income to herself.

The “BET.” Mary’s sole proprietorship may be subject to New Hampshire Business Enterprise Tax (the “BET”) if her gross receipts are more the $222,000 or if she has an enterprise value tax of more than $111,000. The BET is a 0.55% tax assessed on a business’s “enterprise value” tax base, – i.e., the sum of all compensation paid or accrued, interest paid or accrued, and dividends paid by the business enterprise, after special adjustments and apportionment. New Hampshire businesses, including sole proprietorships, may use the BET as a credit against their BPT liability.

The I&D Tax. With certain exceptions, the New Hampshire Interest and Dividends Tax (“The I&D Tax”) applies at a rate of 5% for 2022 to New Hampshire business owners who receive distributions of the profits of businesses in which they have ownership interests and which have “transferable shares.” These include distributions from all state-law business corporations. The I&D Tax does not apply to an individual who is the owner of a sole proprietorship on her sole proprietorship income.

In addition, in my view the I&D Tax should not apply under the relevant DRA regulations to distributions from a single-member LLC to their members as long as their operating agreements provide that their single-member LLCs will be dissolved if their members transfer any interests in them. However, it is unclear whether the DRA agrees with this opinion.

Thus, if Mary converts her sole proprietorship to a single-member LLCs and wants to be certain that she will avoid the I&D Tax on distributions of profits to her, she should add a second member to her LLC — spouses are often the best second members for this purpose — and she should include in her operating agreement either a “consent” provision or a “dissolution upon transfer” provision in accordance with the relevant DRA regulations

John Cunningham is a lawyer licensed to practice law in New Hampshire and Massachusetts. He is of counsel to the law firm of McLane Middleton, P.A. Contact him at 856-7172 or [email protected]. His website is llc199a.com. For access to all of his Law in the Marketplace columns, visit concordmonitor.com.