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March 2006 LLCs and S corporations a compatible duo The popularity of limited liability companies shouldn’t blind you to the distinct benefits of the venerable S corp While limited liability companies (LLCs) seem to be the legal entity of choice for many business owners, it is still wise to consider whether using an S corporation, alone or in conjunction with an LLC, is appropriate. This strategy, which lets you acquire or manage your business or real estate and maximize the limited liability benefits with more favorable tax treatment, has really rendered the use of a sole proprietorship or general partnership to the inexperienced. An LLC is generally taxed as a partnership. An LLC can, however, elect to be treated for tax purposes as an S corporation or a C corporation. In this article we are assuming that the LLC is taxable as a partnership. An S corporation and an LLC are formed in very similar ways. Each has documents that allow for their creation as well as rules that govern the entity operation. Another similar issue of concern involves ownership by multiple parties, i.e., multiple shareholders or members. In either an LLC or a corporation, the parties should enter into a buy/sell agreement to govern their rights upon the occurrence of certain events, such as divorce, death or disability. As similar as the two entities are, the differences are important. For instance:
Perhaps the two most significant differences, though, involve tax treatment. When an LLC is capitalized with an asset, that asset can be distributed to its members without taxable consequences. For example, if two partners form and capitalize an LLC with two pieces of property, they could subsequently distribute one property to one member and the other property to the other member without incurring any tax consequences. This is true even if the distribution occurs many years after the acquisition. That is not true with an S corporation. When the assets that were used to capitalize a corporation are divided between the owners, that normally gives rise to a taxable event to each shareholder receiving a distribution. The impact can be profound, in that the shareholder is taxed as though there were a sale from the corporation at fair market value. In other words, years of appreciation within the respective properties would be subject to taxation. While there are a unique set of rules which allow a corporation, in limited circumstances, to be treated in the same way as the LLC, the entire issue can be avoided by using the LLC form of ownership for any asset which is appreciating in nature. Withholding tax. Perhaps the most important feature of an S corporation, which allows it to continue to thrive, is the ability to distinguish between wage earning income (which is subject to withholding tax) and income that is derived as a return on investment. Any person who is self employed or employed by an entity in which he or she is the owner is subject to wage withholding tax (as is any employee). But as the employer, this business owner is also paying the employer’s portion of the withholding tax on his own income – amounting to a “penalty” of 15% or more on wages up to the FICA limit. An S corporation is the only method of ownership that clearly allows you to distinguish between what you earn as an employee and what you earn as a return on your investment. With respect to C corporations, the return on investment money is subject to double taxation, which is roughly equivalent to the wage withholding tax penalty. The wage-earning services that you are performing on behalf of your corporation are easy to quantify. You can bypass the double taxation if you qualify to be an owner of an S corporation and pay yourself a wage that is reasonable by industry standards. You are entitled to a return on your investment, and you can avoid paying withholding tax on the non-wage earning portion. There is, however, a method of recognizing the beneficial attributes of an LLC and an S corp when it comes to investing in and managing real estate. By holding the asset in an LLC, you protect your appreciation from potential taxation. By managing the asset pursuant to a management agreement through an S corp, you are able to distinguish between compensation for services rendered and income that is a return on investment. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
