Thought Leadership on Tax Planning presented by Thomas & Libowitz.
According to data published by the Internal Revenue Service in 2013 regarding entity filed tax returns, in 1980 approximately 53% of all businesses filed C corporation returns, 13% filed S corporation returns, and only 3.5% filed partnership returns. By 2008, C corporation returns represented less than 20% of all business returns, S corporations had increased to over 45% of returns, and partnerships had increased to 35% of returns. Clearly, the trend is in favor of pass-through entities rather than C corporations. But, since both S corporations and LLCs are pass-through entities (LLCs being taxed as partnerships), how does one decide which choice to make? Considering the six questions set forth below may make the decision easier.
- How important are employment taxes? In 2015, the first $118,500 of W-2 or self employment income is subject to FICA and Medicare taxes at a combined rate of 15.3%; W-2 or self employment income over $118,500 is subject to the 2.9% Medicare tax, and an additional Medicare tax of 0.9% applies to W-2 or self employment income over $200,000 for single taxpayers and over $250,000 for married taxpayers filing jointly.
For an LLC carrying on a trade or business, an owner’s entire share of LLC income is subject to these taxes. For an S corporation carrying on a trade or business, these taxes are only imposed on his or her W-2 income. S corporation distributions are not subject to these taxes. Therefore, for a single individual, the difference between a $200,000 salary and a $300,000 S corporation distribution as opposed to a $500,000 share of income from an LLC is 3.8% of $300,000, or $11,400 in tax savings.
- Who will the owners be? In an LLC, any person or entity can be a member, and there is no limit on the number of members. In contrast, S corporations are limited to 100 shareholders and the types of shareholders are limited to individuals, certain trusts, estates of deceased individuals and certain tax exempt organizations. Partnerships, LLCs, C corporations and other S corporations cannot own interests in multi-shareholder S corporations.
- Are you a newly formed entity, or an existing C corporation looking to convert to S corporation or LLC status? If you are an existing C corporation, the choice becomes relatively clear. Making an S election does not have an immediate adverse tax affect. On the other hand, converting from a C corporation to an LLC is treated as a taxable corporate liquidation, giving rise to potentially significant taxes both at the corporate and shareholder levels. Of course, making the S election is not without consequences that must be analyzed, like built-in gain which would be taxed at the corporate level in the event of a sale of assets within ten years after the election, requirements to recapture LIFO inventory reserves over four years, and requirements to generally change from a fiscal to a calendar year for tax reporting.
- How important is estate planning? Upon the death of an LLC or S corporation owner, the owner’s heirs enjoy a step-up to fair market value basis for the deceased owner’s LLC interest or S corporation stock. However, LLCs may also elect a corresponding step-up in basis of the LLC’s assets. This unique feature permits a subsequent sale of assets at a decreased tax cost. Additionally, remember that only certain types of trusts are permitted as S corporation owners. Any type of trust can be an LLC owner, and this feature permits more creativity in estate planning.
- How do I want to allocate income, losses, and distributions among the owners? With an LLC, different classes of membership interests can be issued having different preferential payments, shares of income, losses and distributions, and different rights to share in the proceeds upon a liquidity event. As long as allocations and distributions have substantial economical effect, there is literally no limit on creativity. On the other hand, S corporations must allocate income, losses, and distributions strictly in proportion to stock ownership because, by statute, all shares must have the same rights to income, losses, dividends and distributions in liquidation.
- Will the entity’s primary activity be the ownership of real estate? If the primary activity of the entity is the ownership, rental and sale of real estate, LLCs have significant advantages over S corporations:
- For an S corporation owner, losses can only be passed through to the extent of the owner’s basis in the S corporation’s stock plus the owner’s basis in any loans made by the owner to the S corporation. The S corporation owner does not obtain basis for S corporation debt to third parties, even if guaranteed by the owner. On the other hand, LLC owners do obtain basis for non-recourse debt loaned to the LLC by third parties, and for recourse debt to third parties which the owners guaranty, permitting them to take losses from real estate operations in excess of their actual investment in the LLC.
- Often real estate owners refinance their property and pocket the excess refinancing proceeds. In an S corporation, these refinancing proceeds result in taxable gain to the owner when distributed if they exceed the S corporation owner’s basis in stock and loans made to the corporation. For an LLC member, the distributions are tax free.
- Almost any third party who purchases real estate wants to be able to depreciate it to the full extent of the purchase price paid. If the seller is an S corporation, the purchaser must purchase the real estate from the corporation in order to accomplish this result. If the seller is an LLC, the purchaser can purchase all of the LLC membership interests or can purchase the real estate and can accomplish this result. However, if the purchaser purchases LLC interests, it might be possible to avoid Maryland transfer and recordation taxes on the purchase which would otherwise be imposed if the real estate was purchased directly from the LLC.
- Finally, employment taxes described in the answer to Question 1 earlier do not apply to rental operations.