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.
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. 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.
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).
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. So you 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! The LLC 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: All profits
generated from this LLC are hit with self-employment tax. You
can’t deduct retirement plan contributions in figuring SE
tax. You can’t form an ERISA pension plan either. Since 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,
who 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 dividends are distributed. 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, as you will soon
see.
S corporations have strict qualification rules:
The corporation can not have non resident aliens
as shareholder.
The corporation can only have one class of
stock.
There must not be more than 100 shareholders.
You must also consider these major disadvantages
to an S corporation:
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 $110,100 and 2.9 percent on the excess for 2012). 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 a single-member
LLC (because the owner is the sole proprietor) is subject to SE
tax. Also, an LLC taxed as a partnership (if the member is deemed
actively involved), could be subject to SE taxes.
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 2012
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 a single-member
LLC or an LLC where each member is subject to SE taxes, you owe
SE tax on your entire $100,000 profit, for a total of $15,300
(15.3 percent up to $110,100). Operating as an S corporation could save you thousands
($15,300-$7,650= $7,650).
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 they 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 start-up 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
two C corporation strategies
A C corporation can actually be the best bet when
you don’t anticipate start-up losses and you can avoid double
taxation. Here are two techniques for keeping taxes to a minimum.
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, 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 35% 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 35 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 an average rate of only 34 percent.
Comparison of LLCs and S and C
Corporations:
LLC
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
* The Charging Order
If a judgement is awarded against
the LLC itself, it may be levied, and LLC’s property seized
or sold in payment (this would be the same result if it were a
corporation). On the other hand, if it is awarded against a member,
to the extent that the operating agreement so states, distribution
usually cannot be compelled to satisfy a member’s judgment
debt (this is why it is critical to have a well crafted operating
agreement, otherwise you have no protection). Creditors have
to satisfy themselves with a ‘Charging Order’.
This gives them the rights to any distributions made by the LLC
to that particular member, but little else.
In such instances, creditors may
find themselves with more problems than profits. Since an assignment
of the rights of income under a charging order may also mean an
assignment of the liability for taxes, the creditor may be given
a K-1 form reflecting the taxable income allocated to the charging
order. They may have to pay the taxes whether any distribution
is made or not! Keep in mind many feel that the creditor should
not get the K-1 unless they received income, but another group
still feels that the creditor may be stuck with the tax bill (this
actually may be an advantage in helping protect your assets because
of this misunderstanding). This will strongly dampen the enthusiasm
of a creditor and also his/her attorney to pursue an LLC member’s
interest in the first place. In the real world this may cause
the creditor to want to either drop the lawsuit or settle for
pennies on the dollar.
Is this going to guarantee
that the assets will be secure? Not always. Why? No matter what
the situation, you are always at the mercy of an U.S. Judge. Even
if this plan was properly formed and there were no challenges
with creditors, the judge may see things differently. For example,
imagine forming this plan, and 5 months later you are hit with
a devastating lawsuit. The judge might claim fraudulent conveyance
and reverse the transfer of the assets to the LLC.
In 1997 Congress enacted Proposed Regulations
on how an LLC would be taxed. The following discusses detail on
what these proposed regulations entail. Just recently, Congress
has banned them from being finalized. This means that they never
were officially approved as law, but they are on the books. That
means there are no guidelines to determine how members or managers
distributions should be handled. A recent tax newsletter made
these comments, " A ban on proposed IRS rules slapping SECA
taxes on limited partners ended earlier this year. But final rules
saying when limited partners owe SECA hasn’t been reissued…and aren’t
likely to be in the near future. Instead, look for cases to arise
in tax audits and be settled or be taken to court and decided
under existing rules, which experts say are far from clear.
Our opinion is that even though no regulations
exist, following the expired proposed regulations as a guideline
would be helpful.
**LLCs and other flow through Entities:
They have income subject to self-employment
taxes. There are exceptions to this:
(ideally you would like to receive income not subject to these
taxes!):
Rental income from real estate and personal
property leased with real estate (except for real estate dealers).
Sec 1402(a) 1
Dividends and interest (except for dealers
in stocks and securities). Sec 1402(a) 2
Gains on the sale of capital assets. Sec 1402(a)
3
Distributive share of income to a limited
partner other than guaranteed payments for services
actually rendered.
This really means that if is you are involved
in an LLC and receive income from the LLC and it is in the form
of rents, dividends or gain on the sale of capital assets,
it doesn’t matter if you are viewed as a general partner
(managing member) or limited partner (nonmanaging member) for
SE tax reasons; this income will not create SE taxes!
Since, many LLCs are operating a business;
the key question is will that income be subject to SE taxes?
Again, many LLCs are simply holding and protecting assets, there
is no other income to worry about which would be exceptions mentioned
above. But more and more companies are operating an LLC taxed
as a partnership, and they want to know how that income distributed
to them by the LLC will be treated? We are talking about active
income being earned by the LLC and how that flows though.
Under the 1997 Proposed Regulations, an LLC member,
for tax purposes, will be classified as a limited partnerunlessone of four tests is met in
which case the member will be treated as a general partner. The
four tests are: (bottom line, if you fall under one
of these tests, you will be viewed as a general partner and your
distributions, unless under one of the exceptions (1402(a), will
be subject to SE taxes).
The Liability Test:
The member faces personal liability for claims against the LLC
(what about running your business through the LLC and you
lease office space and they ask for a personal guarantee, you
are then a GP! Usually, the lessor will not accept your corporation
as the guarantor. The only way is to have another person guarantee
the lease).
The Authority Test.
This requires that the member has the authority to create binding
contracts on behalf of the LLC. (this means if you run your
business through the LLC, you could never sign a contract on
behalf of the LLC. The manager would have to do this.)
The Participation Test:
Here the member must participate more than 500 hours per year
in the business of the LLC. (if you operate a business and are
there everyday, there is no way you will be viewed like a limited
partner).
The Personal Services Test:
The member must provide greater than a de minimis amount
of services on behalf of the business of the LLC, and the business
must involve the areas of health, law, engineering, architecture,
accounting, actuarial science, or consulting. (In other words,
if you don’t form a corporation to avoid the Personal Service
Corporation rules, and you form an LLC that doesn’t have
that category, then you still are trapped if you provide one
of these services to the LLC. You will be viewed as a general
partner!).
Planning tip: Make sure only Managers have the
right to bind the company, not members.
Questions about Forming an LLC or Corporation?
Call NCP at 1-888-627-7007
