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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:

  1. In some states, S corporations are taxed and must file a state level tax return.
  2. 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.
  3. 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$117,000 for 2014 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 $117,000). 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!):

  1. Rental income from real estate and personal property leased with real estate (except for real estate dealers). Sec 1402(a) 1
  2. Dividends and interest (except for dealers in stocks and securities). Sec 1402(a) 2
  3. Gains on the sale of capital assets. Sec 1402(a) 3
  4. 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 partner unless one 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).

  1. 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).
  2. 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.)
  3. 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).
  4. 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 1-800-351-5111

Avoid Costly Incorporating Mistakes!


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There Are Five Primary Approaches to Help You Determine Which Entity Is Best in Your Situation

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Selling a Product with a Partner

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California LLC vs an S corporation- Which is Better? - Learn why understanding state taxation is key!

If Your Business Venture Involves Financing or Net Losses, You Must Read This Section! - A simple S corporation may not    be the best entity when losses are involved.

Why be a Sole Proprietor when There are Better Options - Discover tax advantages with C corporation and S corporation.

Warning: Do You Have Multiple Corporations?- This common strategy may cost you more than you think!

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