What
is the Best Legal Structure to Cut Taxes and Reduce Liability - S Corporation, C
Corporation or a Limited Liability Company?
Now, Explore some real options!
This is not the fluff that you hear elsewhere!
For someone to say that one structure will work best
for all situations doesn’t make any sense. The most favorable choice depends on many factors-the number of owners, the type
of business, whether or not it will be profitable right away,
what type of income will it receive and how all this blends
in with your current situation.
How will Your LLC Be Taxed? You Have Six Options…
And An 83% Chance of Selecting The Wrong One!
Let’s examine the options:
The first basic step is to realize that if you operate
your business as a sole proprietorship or partnership you will have
many worries about losing your personal assets to business-related liabilities
and increasing your chances of an audit!
The solution is to create an entity that has limited
liability. Your choices are S and C corporations and LLCs. With the
LLC we will need to address both the single and multi-member LLC. NCP
prefers LLCs taxed as partnerships, which means, it would have two members.
Most states allow a single member LLC. This is being recommended by
tax practitioners to replace the sole proprietorship. In general it
provides liability protection and an uncomplicated tax picture.
The $50,000 Tax Error
One Wrong Selection… One (yes, just one) Overlooked Form…
And $50,000 Went Down The Drain For One Unfortunate Soul!
Only the member’s investments in the LLC and the
assets in the LLC are generally exposed to liabilities created by business
operations. Personal assets are protected (unless someone can pierce
through the LLC veil, a key reason to form your LLC in Nevada).
Another Reason NOT to Rely On Online Information...
The Options NEVER Come UP!
Many CPAs will recommend a single member LLC to someone
who is currently a sole proprietorship. For federal income tax purposes,
the IRS ignores a single-member LLC. That means the single-member LLC
will be treated as a sole proprietorship. You would continue reporting
business income and expense on Schedule C and computing self-employment
tax on Schedule SE (an LLC taxed as a partnership will not file a Schedule
C.). Schedule C is very highly audited! NCP has a different opinion
for sole proprietorships that is also shared by many other CPAs.
Are You In the Direct Sales Industry?
An LLC Taxed as an S Corporation May be Your Best Option --- IF You Have All The Facts
The LLC taxed as a partnership (with two members) will file a minimally
audited Schedule E. If you take money or assets out of the LLC, there
are no Federal tax complications (taxed as a sole proprietorship). The
same is true if you move money or assets into the LLC.
Procedure: Converting a sole proprietorship into
a single-member LLC usually only involves filing a registration form
with the appropriate state agency and paying a fee. Then the assets
of the proprietorship are moved into the LLC as a tax-free transaction.
Downside: You can’t
deduct retirement plan contributions in figuring SE tax. You can’t
form an ERISA pension plan either. If you are not an LLC taxed
as a partnership there is no charging order protection of the individual
operating the sole proprietorship if he or she gets sued personally.*
In an LLC taxed as a partnership, the manager, will be subject to SE
taxes.**
Another Option Over the Single Member
LLC and
Possible Multiple Member LLC is to Save Payroll
Taxes and Reduce Liability with S Corporation Status
Like LLCs, S corporations offer owners protection against
liabilities generated by their businesses. Specifically, S corps can
take advantage of pass-through taxation, meaning there generally is
no corporate-level federal income taxes to worry about. Instead, all
the company’s income, deductions and tax credit items are "passed
through" to the shareholders, which then report everything on their
Form 1040 and pay the taxes.
In contrast, running your business as a C corporation
can result in double taxation, meaning your business income gets taxed
once at the corporate level and again when liquidated or where there
are retained earnings. Keep in mind this is a simplistic answer. There
are many advantages to a C corporation also and the effects of double
taxation can be minimized or eliminated, as you will soon see.
S corporations have strict qualification rules:
- The corporation must have only US shareholders, estates
or specific types of trusts and can only have one class of stock.
- There must not be more than 75 shareholders.
You must also consider these major disadvantages to
an S corporation:
- The stock of an S corporation is very difficult to
protect from a personal lawsuit, whereas the stock of a C corporation
can be held by a family limited partnership or an LLC taxed as a partnership.
- In some states, S corporations are taxed and must
file a state level tax return.
- If the S corporation owns appreciated assets, they
cannot be distributed to you without triggering an income tax bill.
There is no such problem with a single member LLC.
- If you die, the company cannot step up the basis
of its assets to reflect the fair market value on the date of death.
With a single member LLC and LLC taxed as a partnership, your heirs
benefit from a step-up for most business assets.
Now, let’s look at the tax benefits of an S corporation
over the single person and LLC taxed as a sole proprietorship.
As the shareholder-employee of a solely owned S corporation,
you receive a salary, subject to a 15.3 percent federal payroll tax
(for Social Security and Medicare) on the first $102,000 and 2.9 percent
on the excess (for 2008). The corporation, as your employer pays half,
and the other half gets withheld from your paychecks. The corporation
deducts your salary as a business expense on its tax return (Form 1120S).
Under current law, that pass-through income is not subject
to SE tax. In contrast, all income from an LLC could be subject
to SE tax.
Strategy: Pay yourself a low salary to avoid
federal payroll taxes. Just make sure it’s not too low. Have industry
comparisons on hand to show you’re in the ballpark.
Example: The taxable income generated by your S corporation
business is estimated to be $100,000 for 2008 before you pay yourself.
You take a $50,000 salary. Only that amount is hit with the 15.3 percent
federal social security and Medicare tax, which amounts to $7,650. You
can withdraw the remaining corporate cash flow in the form of distributions
to yourself that will not be subject to SE taxes (this will be added
to your personal income on which you will pay tax at your current tax
bracket).
If you operate the same business as an LLC where each
member is subject to SE taxes, you owe SE tax on your entire $100,000
profit, for a total of $13,427.60 (15.3 percent of the first $102,000). So operating as an S corporation
could save you thousands ($13,427.60-$7,650= $5,777.60).
Remember: You must be able to show that a $50,000 salary
is reasonable. If the IRS thinks it’s too low, it may try to reclassify
all or part of your purported cash distributions as disguised wages.
Select C corporation status when profits are on the
rise.
Like S corporations, the main advantage of a C corporation
is the personal protection from business liabilities. The big disadvantage
of C corporations is that retained earnings are subject to double taxation,
which in turn can mean:
- Payments to shareholders-in cash or property-may
be treated as dividends (ordinary income to shareholders with no deduction
for the company).
- Two layers of tax on retained corporate cash flow
(once when the corporation earns income and again on the resulting
increase in stock value when shares are sold).
- Both corporate and shareholder-level taxes when the
company holds appreciated assets and liquidates so shareholders can
go their separate ways.
- Ditto if the corporation sells all its assets and
gives the resulting cash to its shareholders in liquidation.
Also, if the business will have significant losses in
the startup phase, they can’t be passed through to the owner (they
will carry forward and offset profits from year two). With an LLC or
S corporation, losses can generally be passed through and deducted against
other personal income.
Here is a way to Pay Less to the IRS
with
C corporation Strategies
A C corporation can actually be the best bet when you
don’t anticipate startup losses and you can avoid double taxation.
Here are two techniques for keeping taxes to a minimum.
Caution: Your Tax Professional MUST be on Top Of Your Records for Your C Corporation Strategy to be Effective!
Strategy 1: Try to "zero out" the company’s
taxable income every year with deductible payments that benefit you.
These payments can include salary, bonuses, and fringe benefits, rent
for assets owned by you and leased to the corporation and interest on
loans from you to the company. If the company’s income can be zeroed
out, double taxation is no threat.
Strategy 2: Use a C corporation for a growth
business when you need to maximize cash flow to finance equipment additions
and growing levels of inventories and receivables.
Example: You have a great idea for a new business.
Personally, you’re already in the 39.6% tax bracket because of
income from other sources. The new business will make money, but you
need to maximize cash to finance growth. If you set up as a single-member
LLC or S corporation, you’ll have to withdraw 39.6 percent of the
new venture’s income each year just to pay your personal taxes.
But if your set up as a Corporation, the company pays
only 15 percent on its first $50,000 of taxable income and 25 percent
on the next $25,000. In fact, you can have taxable income up to $10
million and pay a highest rate of only 34 percent.
Comparison of LLCs and S and C Corporations:
| |
LLC * (depends on how LLC is taxed) |
S Corporation |
C Corporation |
| Tax at personal
level |
Distributions may
be subject to SE taxes. |
After salary, remaining
distributions are not subject to SE |
Not a flow through
entity; it files its own tax return. |
| Entity Tax Rates |
No tax at entity level |
No tax at entity level
(usually) |
15% on first $50,000
in profits. |
| Asset Protection
at Personal Level |
May be partial or
complete at personal level (depends on how the LLC is taxed). |
None |
None |
Which State to Incorporate In?