When you form an LLC, you have four options on how it may be taxed, disregarded, S or C corporation, or a partnership. There are a lot of factors to consider which taxation type may be best for your situation. In this case study, we address the key questions you must consider. Here is our hypothetical situation that will help you better evaluate your own situation.
Situation: My partner and I own rights to computer software, and we’re going to market it across the US as a new security program for computer systems.
- What are you expecting in the way of Gross Sales during your first 12 months?
- What will your business expenses and net profit be?
- 300k expenses
- 600k net profit, before paying myself and partner.
- Do you have a partner for your business?
- What is your personal income level (aside from this new business)?
- We each earn over 150k from a computer-consulting contract.
Here are the key questions to ask next to help determine which entity may be best in this situation:
- You mentioned you’re selling a product. Will you be providing services as well?
- 100% product, computer software.
- Will your business develop a net worth? Meaning, will it develop systems and have a net value over time? Or is it based upon your efforts, so that the day you stop working is the day your company stops generating revenue?
- Yes, this product already has a net worth, and, as it becomes known in the marketplace, the value will skyrocket! Yes, this will be a very profitable business, where we only need a couple of employees, and we won’t have a lot of overhead.
- Will your company hold large inventories or receivables?
- No, only some computer equipment. The software is replicated as orders come in.
- Will your business be purchasing a lot of equipment with debt? (Important if you’re expecting to break even or lose money during the first year.)
- Is your goal to sell the business soon? (Important for C-corporation consideration.)
- Yes, it might be possible to sell it for several million in a few years to a big software company.
- Will the entity keep profits as retained earnings for future growth and expansion? (Another important C-corporation consideration.)
- No, we make too much profit as it is. We don’t need a lot of money for growth and expansion. Because of our background, we already have distribution channels and contacts interested in our product!
- Are you looking for Investors for your company?
- Perhaps in the future.
- Do you have other C-corporations? (We only ask if we think a C-corporation might be the best choice at this time; important for new entity-controlled group issues.)
- Are you a US citizen or a Resident Alien? (An important S-corporation question, as nonresident aliens, cannot own S-corporations.)
- Yes, I am a citizen, but my partner is from Europe.
- What states will you be operating in? (Important for state tax consequence consideration.)
- I live in Nevada, but my partner is in Europe.
Conclusion: Consider Two Aspects; Tax and Liability Point of View:
Result: You will NOT be a C-corporation because:
- Your 600k in expected net profit is too much to reinvest in a C-corporation. You’d have a retained earnings tax problem, as C-corporations may have only 250k in retained earnings-unless they have a good reason. Excessive retained earnings cause double taxation when you want to take some of the profit from the C-corporation in the future.
- You are not looking to reinvest the money into the company, nor will you add a lot of employees.
- Since you might sell the company in a few years, a C-corporation would give you double taxation problems. When you sell the business, what happens is the buyer purchases the assets from the existing entity; they’re not buying the corporate stock. When the existing C-corporation sells its assets, it receives a large check payable to the C-corporation, which would then have to pay taxes on all that profit. It would also have to file a final tax return when you dissolve the corporation, and you would pay taxes again, personally. You can avoid this double taxation problem with a flow-through entity.
You will NOT be an S corporation because:
- You have a partner that is a non-resident alien. A non-resident alien can not own the stock in an S-corporation.
- If you bring in an investor down the road, the S-corp limits that investor’s investment options. They can only invest as an individual, an S-corp, or single-member LLC. They cannot be a foreigner. An LLC is taxed as a partnership or a C-corporation.
- S-corporation stock is not as easy to protect as that of a C-corporation or LLC. A single-member LLC could own an S-corporation stock, but the protection is not as clear-cut as that provided by an LLC taxed as a partnership.
You will be an LLC taxed as a partnership because:
- You have a partner.
- Your company has a net worth, and the LLC taxed as a partnership is equipped with the “Charging Order” protection.
- You have too much profit for a C-corporation, so you need a flow-through entity.
- You might sell the company, which works better with a flow-through entity, and, as we discussed, the S-corporation is NOT an option.
- A single-member LLC is not an option either, because you have a partner.
Look at the Liability Point of View:
Example of Liability: The LLC taxed as a partnership gives you built-in protection through the “Charging Order” that applies to all LLCs, but more so to LLCs taxed as partnerships.
When you come together with a partner, the main concern is to find out if your partner has any “baggage” in the closet that will come out when your new business starts to make money. For example, does your partner have existing creditors in other states that you don’t know about? Did you know that judgments in other states can be carried into a new state?
An LLC makes it more difficult for any of this baggage to have direct implications for your company. If you or your partner get sued personally, it’s more difficult for a creditor to control the LLC’s ownership interest. If you owned a C- or S-corporation, the creditor would take over the stock and be the new owner.
Charging Order: When a creditor goes after you personally, and the only major asset to collect against is your membership interest, the court will limit the creditor by what is called a “charging order.” If you’re sued personally, and if you own the stock of an S- or C-corporation, a creditor would take over the stock, or enough of the stock, to satisfy the judgment. On the other hand, a charging order gives your creditor the right to an “economic interest” of the membership interest. All that means is that they get access to profit distributions represented by that membership interest (same as ownership interest).
For example, if both you and your partner owned the LLC 50/50, you’d share the 600k profits and get 300k each. If you had a judgment against you for 400k, the creditor would have access to your 300k in distributions to pay off the 400k in judgments, IF, AND ONLY IF, the LLC ACTUALLY DISTRIBUTES THE PROFITS! If the LLC does not distribute the profits, the tax liability still flows through to you, and you still have to pay the taxes out of your pocket. So far, the creditor has not received any money to pay down the judgment he has against you.
Note that the creditor does NOT get a MANAGEMENT INTEREST, which would allow him VOTING RIGHTS, and therefore CONTROL of 50% of your company. If a creditor has CONTROL, they may sell tangible assets to settle the judgment. This does not happen with a charging order. Your creditor gets an ECONOMIC interest only and must wait patiently for financial distributions.
This concept is so powerful that many states are changing their legislation to say that if an UNREASONABLE AMOUNT OF TIME goes by, and if it APPEARS that the CREDITOR will NOT RECEIVE ANY DISTRIBUTIONS with which to PAY OFF THE JUDGEMENT, the CREDITOR will have the RIGHT to GO BACK to the Court, and ASK FOR FORECLOSURE ON THE MEMBERSHIP INTEREST…which gives the creditor CONTROL of MANAGEMENT INTERESTS AS WELL!!! And if your creditor has management interests, they have assets that they can sell to satisfy their judgment.
Yes, it means more legal fees and more work, but in the creditor’s eyes, it’s at least an option to get something!
Creditors must follow a TWO-STEP APPROACH to get CONTROL of a MEMBERSHIP INTEREST of your LLC, versus the procedure to collect if you own an S- or C-corporation:
Step 1: Obtain a charging order and hope for distributions.
Step 2: If no distributions, go back to the Court and ask to FORECLOSE on the MEMBERSHIP INTEREST-a trend in many states.
Bottom line? The LLC taxed as a partnership gives you more personal protection than just owning a C- or S-corporation stock. If you form a C-corporation, you can form a second entity to own the stock-an LLC taxed as a partnership, ideally. An S-corporation can only have a single-member LLC as an owner with the charging order protection but is not as strong. By the way, the charging order protection came from limited partnerships and carried over to LLCs.
BONUS Strategy: Prevent a Creditor from Disrupting the Operations of Your LLC
If a creditor obtains a charging order against one member, the LLC, based on the manager’s decision, probably WILL NOT distribute any profits that year to frustrate the member’s creditor. Both members then receive a K-1 but no money to pay the taxes, so both must borrow from the LLC to pay their respective taxes. This may cause the other partner to feel very uncomfortable.
SOLUTION: Require that each member (partner) form their own PERSONAL LLC to hold their membership interest in the main operating company.
- The LLC holding company will only own safe assets.
- A charging order will only affect the member’s personal LLC, not the main operating company!
Here’s what it looks like:
Look at the Tax Point of View:
It would help if you Considered These Key Factors:
1. 900k in gross sales
2. 600k in net profits
3. 150k in other earned income
4. Too much profit for a C-corporation; need a flow-through entity
If you’re 50/50 owners, each of you will split the 600k in net profits. The KEY QUESTION is, “ARE THESE PROFITS SUBJECT TO SE TAXES?”
LLC Members’ Exposure to Self-Employment Tax
What are self-employment taxes?
The SE tax is designed to ensure that self-employed individuals pay the Social Security and Medicare taxes (payroll taxes) that an employer would otherwise be withheld. Generally, employers and employees each pay a 6.2% Social Security tax on wages up to a wage base ($142,800 in 2021) and a 1.45% Medicare tax on all wages. Thus, self-employment income is subject to a 12.4% Social Security tax (up to the wage base) and a 2.9% Medicare tax.
You are considered self-employed if you conduct a trade or business as a sole prop, single-member LLC disregarded owned by you, or a member of an LLC taxed as a partnership. Managers of an LLC and general partners of a partnership pay self-employment taxes on all their business income from the partnership, even if it is not distributed.
There is a difference in LLC members of an LLC taxed as a partnership as to their profits being subject to self-employment taxes. They are subject to self-employment taxes on “guaranteed payments,” which are for services to the LLC but exempt from self-employment taxes on their distributive share of partnership income. Here are more details below on LLC partnership taxation.
When it comes to computing the amount of a partner’s self-employment (SE) income, the general rule is that the partner includes his or her pass-through share of the partnership’s income and loss from a trade or business activities as SE income [IRC §1402(a)].
However, limited partners only include guaranteed payments from the partnership for services actually rendered to the partnership in their SE income, as described in IRC § 707(c). [See IRC §1402(a)(13).] Such payments are commonly referred to as “partner salaries.” This is a favorable rule, assuming the partnership’s trade or business activities generate taxable income because it minimizes the limited partner’s SE income and SE tax.
The SE tax rules were developed before an LLC taxed as a partnership existed. The question became: How do LLC members deal with SE tax and, specifically, when can they escape SE tax on the theory that they should be considered limited partners because they aren’t personally liable for LLC debts?
If limited partner status applies to LLC members for SE tax purposes, they apparently can avoid SE tax simply by not receiving any section 707(c) payments for services. Obviously, big dollars could be at stake, particularly for professional service LLCs.
In response to this “alarming” situation, Treasury issued not one but two sets of proposed regulations (in 1994 and 1997) on the subject of SE tax for limited partners (LLC members). Both generated controversy by proposing that LLC members be required to pay SE tax on certain LLC pass-through income, in addition to any Section 707(c) guaranteed payments for services.
Many commentators interpreted the proposed rules as imposing new taxes on LLC members without the benefit of any supporting legislation. Congress agreed. Section 935 of the Taxpayer Relief Act of 1997 includes language prohibiting the release of any temporary or final regulations on the subject before July 1, 1998. Treasury now concedes that the proposed regulations are not valid. As this is being written, there is no indication that the Treasury’s further guidance will be forthcoming until Congress delivers a statutory clarification.
Thus, an aggressive interpretation of current law is that LLC members can completely avoid SE tax on their pass-through shares of LLC income by avoiding any Section 707(c) guaranteed payments for services. However, the IRS may take the position that at least some of the cash distributions received by LLC members are, in fact, “disguised” Section 707(c) guaranteed payments for services.
NOTE: The downside of taking the position that LLC members have little or no SE income is that it may severely restrict their ability to contribute to any tax-deferred retirement plan. Annual contributions to an individual’s self-employed Keogh plan or SEP account are based on the amount of his or her SE earnings for the year [IRC §4O1 (c)(2)]. The same is true for SIMPLE-IRAs [IRC §408(p)(GXA)(ii) 1.
A less-aggressive approach might be for LLC members to concede that they owe tax on a “reasonable” portion of their cash distributions by voluntarily treating such reasonable amounts as Section 707(c) guaranteed payments for services. The members can then make a strong argument that they owe no further SE tax because they have taken a conservative approach to interpreting a very unclear law.
NOTE: There is no confusion regarding the SE tax for individual owners of single-member LLCs involved in a trade or business activities. The existence of the single-member LLC is ignored for federal tax purposes. Accordingly, the business is treated as a sole proprietorship activity of its owner, with the resulting exposure to the SE tax1.
We know that you only pay SE taxes up to $142,800 in 2021. Since both already earn 150k personally, they are above that level. BUT, 2.9% of the SE tax is a portion called Medicare taxes. You pay the 2.9% on any income ABOVE $142,800 to an UNLIMITED AMOUNT of EARNED INCOME (passive income, like rents, are NOT subject to SE taxes or the Medicare portion).
HOW DOES SE TAX WORK WITH LLCs TAXED AS PARTNERSHIPS?
Typically, if LLC members are ACTIVELY INVOLVED in running the business, any LLC profits are deemed EARNED INCOME, and therefore subject to SE taxes!
Passive members of an LLC, such as a spouse who is not involved in the business, would receive income that is NOT subject to SE taxes.
Some CPAs are still treating LLCs taxed as partnerships like S-corporations when there is an even balance between salary and distributions; EXCEPT that in LLCs, it’s called GUARANTEED PAYMENTS and DISTRIBUTIONS. Guaranteed payments are subject to SE taxes, BUT distributions are NOT! The key is to take a reasonable salary. In other words, you cannot take a $5,000 salary with $95,000 of distributions to save more in SE taxes. That is not a reasonable salary.
Conclusion: From a tax point of view, the LLC taxed as a partnership, at best, will bring you the same result as the S-corporation. At worst, the members would pay 2.9% for the Medicare portion above $137,700 in 2020. But the LLC still brings benefits for all the other reasons! (Besides, in this example, an S-corporation is not an option because of the foreign partner.)
What Happens Each Month:
Each Partner receives a GUARANTEED PAYMENT each month. In this example, it might be 10k. If you take a distribution, WRITE A SEPARATE CHECK, and notate “DISTRIBUTION” in the memo field, as taxes will not be withheld on this amount. You will personally pay all the taxes at the end of the year, and after the first year, you’ll make quarterly estimated tax payments. At the end of the year, the LLC will issue you a K-1, representing the company’s distributions and guaranteed payments that flowed through to each partner! The money may not all be distributed, but you certainly have to pay taxes on your LLC profits. Keep in mind that guaranteed payments are an expense to the LLC, which lowers net profits.
WARNING: It’s easy to figure out that you can save more of the 2.9% Medicare portion of your SE taxes if you have lower guaranteed payments and higher distributions. In this example, if you received $40,000 in guaranteed payments and $240,000 in distributions-just to save 2.9% on the $240,000, or $6,960 (remember both already earn $150k separately), the IRS will JUMP all OVER YOU! They don’t like people abusing LLCs by taking too LITTLE in guaranteed payments and too HIGH DISTRIBUTIONS.
A Few Other Points:
Tax Return Filed: 1065 for LLC taxed as a partnership.
Due Date: March 16th (2021)
Year-End: Calendar year-end, December 31st.
Some states do have a state-level tax on LLCs.