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This article will compare the federal tax effects of entity selection. This article will be relevant to all taxpayers throughout the country but at times may point out New York State specific issues. I will further explain the pros and cons of both an S-Corporation and an LLC from a tax professional point of view.
What is an S-Corp?
There is no such thing as an S-Corp or S-Corporation entity! When people discuss S-Corporations they are talking about corporations that have made a tax election to be taxed as a flow-through entity similar to that of a partnership.
Interesting Fact: The “S” in S-Corporation refers to subchapter S of the Internal Revenue Code!
Do you want to be taxed as an S-Corporation?
The answer is Yes! Anyone who has ever taken a business law class will tell you that corporate income is subject to double taxation! Once at the entity level and again when dividends are paid to shareholders (dividends are taxable income to shareholders).
It is possible for an eligible corporation to avoid double taxation by electing to be taxed as an S-Corp. An S-Corp is a flow-through entity for tax purposes which means income and expenses are reported but not taxed at the entity level. The income and expenses are then allocated to each shareholder based on the number of shares owned. The shareholders will then pay tax on their share of income and expense on their individual tax returns.
Are you eligible to make an S-Election?
In general, a domestic corporation may elect to be taxed as an S-Corporation if:
- It has no more than 100 shareholders*
- It has no nonresident alien shareholders
- It has only one class of stock with identical rights to distributions and liquidation proceeds
*The type of shareholders also matters shareholders should be individuals, trusts, and estates. The reason for this is it would completely defeat the purpose of limiting entity to 100 shareholders if those shareholders themselves could be partnership entities with many partners.
How does a Corporation make an S-Election?
File Federal Form 2553 (instructions)
Important Note: This is a Federal tax election. It is important to verify if you also need to make a tax election at the state level. Example: A New York Corporation that has made the federal election would also want to file Form CT-6 to be taxed as a flow-through entity at the state level. You would be surprised how many attorneys make the election at the federal level and forget about the state.
Additional Note: NYC does not recognize S-Corporations! Even if you made the election at the federal and state level you may still be filing a nyc corporate tax return (if required) and paying corporate income tax at the entity level.
Advantages of conducting business as an S-Corp
Besides avoiding double taxation; S-Corps have been used to avoid payroll/self-employment taxes. Pass-Through income from an S-Corporation is not subject to self-employment taxes whereas if it was a partnership pass-through entity it may be subject to self-employment taxes.
There are two ways for the owner of an S-Corp to pay himself:
(1) Salary (subject to employment tax)
(2) Distribution (not subject to self-employment tax).
In general distributions are profits from the business being “distributed” to owners. Small business owners would rather take no or very little salary and be paid via distribution. The IRS is aware of what is happening and requires employee-shareholders of S-Corps to take a “Reasonable Salary.” The IRS may reclassify distributions as wage expense subject to employment taxes.
Note: health insurance premiums paid by the S-Corp for the benefit of an employee-shareholder should be reported as wages (not subject to social security & medicare taxes) on the shareholder’s W2. The shareholder subsequently would take an “above the line” self-employed health insurance deduction on their individual tax return.
What is an LLC
LLC is the abbreviation for Limited Liability Company. An LLC offers the limited liability protection of a corporation with the flexibility of a partnership. An LLC will not have to deal with corporate formalities i.e. board of directors or annual meetings. Instead, the LLC is managed by an Operating Agreement which is similar to that of a partnership agreement.
Advantages of conducting business as an LLC
An LLC is a magical entity in the income tax universe! I ♥ LLCs! An LLC can be taxed in various ways:
- Disregarded Entity- A single-member LLC is considered a disregarded entity for income tax purposes. This means that the business is treated as if it was never formed for income tax purposes. You do not need to file a separate tax return for the LLC. The income and expenses of the entity are reported on the individual tax return of the owner. This may be a reason for someone to form an LLC over a corporation. You will save money annually on tax preparation as most accountants will charge a minimum of $500-$750 for a corporate income tax return.
- Taxed as a Partnership– If the LLC has more than 1 owner than it will be taxed as a partnership.
- Taxed as a Corporation- an LLC can make a tax election and be taxed as a Corporation.
It is for these reasons that most tax professionals would say that an LLC is a superior entity for tax purposes because an LLC can be taxed as a Partnership or Corporation! However, it is very expensive to form an LLC in New York due to the LLC publication requirement. Therefore, it would not make financial sense to form an LLC in New York if you are planning to make the election to be taxed as a corporation.
LLC Taxed as a Partnership
An LLC with multiple partners will file a partnership tax return (Form 1065). Partnerships are the original flow-through entity. Although Partnerships and S-Corps are both flow-through entities there are differences as they are subject to different sections of the Internal Revenue Code.
Special Allocations: The best thing about partnership tax is that income and expenses can be specially allocated to partners according to the partnership agreement (you cannot do this with a corporation).
EXAMPLE: To demonstrate, two individuals (1) Joe Worker and (2) Joe Money go into business together making widgets. They agree on being 50/50 partners in the new venture. They draft an operating/partnership agreement: Joe Worker will work full time for the business and receive a guaranteed payment (salary) of XXXX for services performed. Joe Money will be the “money guy” providing all the capital to get the business off the ground. However, as part of the deal, Joe Money will receive all the cash distributions (if any) until he gets his initial investment back. Additionally, if the business is not profitable any losses will be allocated to Joe Money to the extent of his initial investment.
Guaranteed Payments: You cannot be both an employee and a partner in the same Partnership. The reason is employees are subject to employment taxes and paid wages. While partners are subject to Self-Employment Taxes and receive a guaranteed payment for services performed for the partnership.
Note: This is very different than an S-Corp where an owner can be both an employee and a shareholder.
A Guaranteed Payment is a gross payment (no taxes withheld) to a partner for services performed. The partner would then be responsible to make quarterly estimated tax payments.
Real Estate: As a general rule of thumb never hold real estate in a corporation. The more appropriate entity would be an LLC. Appreciated property distributed out of an S-Corp would be taxable but if distributed out of an LLC would not be taxable. Additionally, if there is a mortgage on the Real Estate there are tax advantages to having it in an LLC vs S-Corp.
Basis Issues: In general cash distributions from an S-Corp and Partnership are tax-free to the extent of the taxpayer’s basis in the entity. Distribution in excess of basis is treated as a capital gain. Another big difference between an S-Corp vs Partnership is the increase in basis for entity debt. A partner’s basis in a partnership will increase by his share of partnership debt. There is no similar increase in basis for shareholders of an S-Corporation.
This article addressed the major difference that needs to be considered before choosing an entity for your business. In practice S-Corps are very popular with consulting and management companies; LLCs are very popular as a (1) disregarded entity, (2) where ownership of Real Estate is involved (3) situations that require an agreement between owners on how the income and expense should be allocated.
If you liked this article you may like these related articles:
- Never Hold Real Estate in a Corporation
- S-Corporations and the REASONABLE SALARY
- Should a New York Business be a Delaware LLC
Disclaimer: This article is offered for general information and educational purposes and not intended to be tax or legal advice.