What is the most beneficial tax structure for a restaurant or bar in Washington, DC? The tax law in DC is different from your typical state, and the Tax Cuts and Jobs Act (TCJA) of 2017 changed many rules of thumb that historically applied to small businesses. As a result, you have probably received convoluted and contradicting responses to this question.
This article will outline why DC restaurants and bars play by different rules and walk you through the most advantageous tax structure for your restaurant or bar in DC that will maximize tax savings. If you haven’t done so already, we recommend reading the primer to this article, The Best Tax Classification for Your Restaurant, which outlines the ideal tax entity type for your restaurant(s) based on your goals.
Taxation of LLCs
S-corporations, Partnerships, and Schedule C taxpayers are flow-through or pass-through entities because their income “flows” or “passes” to the partners/shareholders and gets taxed on their personal returns. On the other hand, C corporations pay taxes at the entity level and then get taxed again on the same income at the personal level. This double taxation means C-corporations are rarely the entity of choice when minimizing taxes. Therefore, we will only discuss and consider pass-through entities for the remainder of this article.
In addition to pass-through treatment, S-corporation profits are not subject to a 15.3% self-employment tax (social security and Medicare), making them the entity of choice for the last 30 years for restaurants with one class of ownership, less than 100 shareholders, and no foreign shareholders. This “rule of thumb” changed after the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA introduced the qualified business income deduction (QBID), which allows pass-through entities to deduct 20% of their qualified business income (subject to some limitations) for federal tax purposes. This made S-corporations less attractive because S-corporation officers must pay themselves reasonable compensation, which reclassifies the business profits that qualify for the QBID and forgone self-employment tax to W-2 wages that are subject to income tax and social security/Medicare taxes. We discuss this further in The Best Tax Classification for Your Restaurant.
Taxation of Pass-through Entities in DC
Now that you know the advantages of pass-through entities, let’s see why DC is so different. DC plays by a different set of rules regarding pass-through entities. DC does not recognize pass-through entities; they classify S-corporations as corporations and partnerships and schedule C taxpayers as unincorporated businesses, thus complicating tax planning.
A DC S-corporation’s profits are taxed at 8.25%.
A DC unincorporated business’s profits are taxed at 8.25%.
In addition to these taxes, the partners and shareholders pay income tax on their personal returns on the same income, thus exposing them to double taxation! In some cases, this can be up to 18%+ state income tax on the business income, depending on the state that they live in. For example, if a partner lives in VA and owns a business in DC, they will pay the 8.25% tax in DC on their restaurant’s income and 5.75% on the same income in VA on their personal returns. This can have devastating tax consequences. However, DC residents are excluded from this double taxation. If a partner or shareholder of a DC restaurant is a resident of DC, they are NOT double taxed on the same income because they can take credit for the taxes paid by the business in DC on their personal DC tax returns.
There’s no escaping double-taxation of a restaurant or bar in DC for partners or shareholders outside of DC unless your state allows you to take credit for DC corporate taxes paid at the entity level on your personal returns. Few states allow this.
What are my options to maximize tax savings in DC?
Since DC imposes an entity-level tax on all restaurants, you can be taxed as an S-corporation or Unincorporated Business. By default, LLCs are considered unincorporated businesses in DC and a partnership or schedule C (single member LLC) for federal purposes. However, you can make an election to be an S-corporation for both federal and DC tax purposes if you qualify.
You can’t qualify as an S-corporation if you have multiple classes of ownership (class A, class B, etc.) that give investors preferred distributions. This automatically disqualifies many restaurants and bars. Other qualifications exist for S-corporation treatment, but this hurdle is typically difficult for bars and restaurants to overcome. You can circumvent this limitation by structuring a management company as an S-corporation and assigning ownership of the partnership to the S-corporation. For example, your class A partners could be in your investors who receive preferred distributions, and your class B partner is your management company which is owned pro-rata by managing partners.
Now that we have laid the groundwork let’s look at some examples to show you the tax implications of a partnership versus an S-corporation in DC. For this exercise, you can assume a single-member LLC (or Schedule C taxpayer) has the same tax implications as a partnership without guaranteed payments.
*When calculating DC taxable profits for an unincorporated business, you must add back guaranteed payments to partners for services performed (see Guaranteed Payments vs Distributions), which were deducted for federal purposes, but you can deduct a fixed allowance for owners’ deemed salaries and a maximum $5,000 exemption.
As you can see in the examples above, an S-corporation can reduce your tax liability significantly. However, the examples above assume the partnership issues guaranteed payments or a management fee to managing partners. A guaranteed payment (like W-2 wages paid to owners in an S-corporation) doesn’t qualify for the QBID. Therefore, it sways the benefits towards an S-corporation. Instead of becoming an S-corporation, you can reclassify your guaranteed payments to profit distributions if your operating agreement allows it. In a partnership with outside investors, this will most likely not work. However, this is possible in a single-member LLC or partnership with pro-rata ownership. This is common in a partnership owned by two partners who are actively involved in running the restaurant. To do this, it’s important to understand the difference between guaranteed payments and distributions. Let’s see the overall impact on total taxes if you convert all of your guaranteed payments to distributions:
*When calculating DC taxable profits for an unincorporated business, you must add back guaranteed payments to partners for services performed (see Guaranteed Payments vs Distributions), which were deducted for federal purposes, but you can deduct a fixed allowance for owners’ deemed salaries and a maximum $5,000 exemption.
After converting guaranteed payments to profit distributions, an S-corporation becomes less advantageous; nonetheless, it’s still advantageous.
An S-corporation is generally the most advantageous tax entity type for a restaurant or bar in DC to maximize tax savings.
Conclusion
We have used two generic and straightforward examples above to outline the differences between the taxation of an S-corporation and an unincorporated business in DC. A similar analysis needs to be prepared to determine the most advantageous tax entity type for your restaurant based on your facts and circumstances such as the number of partners, residency, wages, owner’s involvement in the restaurant/bar, owner’s wages, and more. Your accountant should be able to prepare this analysis using their tax preparation software. At The Fork CPAs, we do this analysis for every client in our firm during their onboarding process because it lays the foundation for successful tax planning. Please check out what we do for other restaurants and bars in DC, and if you’re interested in speaking with us, schedule a discovery call here.
