Forming a LLC: Partnership or S Corporation Taxation
We have reviewed the considerations for choosing your business formation type between a limited liability company (LLC) or corporation. You have discussed the choices with your startup lawyer. Before your attorney registers your new business, you need to know the implications of your business formation type on the taxes that your business and its owners will pay. The required caveat is that I am not a tax lawyer, and the tax consequences for you, your investors, your new business and anybody else should be reviewed by a tax professional. This blog post points out some of the major considerations that you may want to keep in mind when starting a LLC and choosing how you want your startup to be taxed.
Related article: Forming a New Business: Corporations vs LLCs
You should keep in mind that limited liability companies are creatures of state law, meaning that registering a LLC, the duties of its members and managers, and anything else dealing with the status of the LLC is governed by state law. On the other hand, the taxes you pay to the federal government are governed by, not surprisingly, federal law. There is still a state law tax regime that you need to be concerned about, although I will focus here on federal tax law.
Under federal income tax law, all business entities, and that of course includes LLCs, fall into one of three pots: they are “disregarded” or they are treated as a partnership or they are treated as a corporation. Disregarded does not mean that you don’t pay tax; it means that the entity doesn’t pay tax. The owners, stockholders, members, partners do pay tax. This blog post addresses federal tax law, and the two kinds of taxes that business owners are primarily concerned about when forming a new business: income tax and social security taxes.
For most startups, choice is between a LLC taxed as S corporation and LLC taxed as partnership
Let’s assume that you want to organize your startup as a limited liability company. A LLC can be taxed as a sole proprietorship, partnership, S corporation, or C corporation. The default for the IRS is that the LLC will be taxed as a sole proprietorship if there is only one member, and will be taxed as a partnership if there are two or more members. Consequently, if the new business owner does not make an election, and the business owner is the only member, the LLC will be taxed as if it were a sole proprietorship. If there are two or more members, and no election is made, the IRS will treat the LLC for tax purposes as a partnership.
Summary of business forms for tax purposes. There are circumstances when the new business may want to consider organizing as a corporation, but for the purposes of this article, I am assuming that as for the vast majority of new businesses, you will organize as a limited liability company and the essential question is whether you elect to be taxed as a corporation under the so-called “check-the-box” regulations. This is a summary of the various business forms of business for tax purposes:
- 1. Sole proprietorship: Disregarded entity. Usually reports LLC income and expenses on Schedule C (profit or loss from business) or sometimes Schedule E (supplemental income and loss for rental real estate, partnerships, S corporations, etc.)
- 2. Partnership: Pass through entity. Subchapter K. Files informational Form 1065 (return of partnership income). Issues K-1s to members.
- 3. S corporation: Pass through entity. Subchapter S. Files Form 1120S. Issues K-1s to members.
- 4. C corporation: Subchapter C. Files Form 1120 (corporation income tax return). Issues Form 1099-DIV when dividends are paid to shareholders.
Check-the-box election: You may file an election (check-the-box) to request the Internal Revenue Service (IRS) to tax your new business as a corporation, even if your business is organized as a LLC. The election is a two-step process: first you elect to be taxed as a corporation (usually on Form 8832), and then elect to be taxed as a S corporation (Form 2553). The IRS makes this election easy as your election on Form 2553 will be deemed to be an election to be taxed as a corporation and you don’t have to file Form 8832. The two step process is significant because if your S corporation election is invalid, then you may be taxed as a C corporation. If you want a reminder of what requirements your new business must meet to be taxed as a S corporation, then you can go back to the blog post on organizational considerations for S corporations.
Remember that a S corporation can only have one class of stock (membership interests), no more than 100 members, no foreigners holding membership interests, and no corporate members. Those are the major constraints of a S corporation, but there are other circumstances under which you can inadvertently lose your S corporation election. Passive income such as rent payments, dividends and royalties is limited to 25 percent of the revenue for a S corporation. If the S corporation has accumulated earnings and profits (relevant if the S corp was previously a C corp) and earns more than 25 percent of its total gross receipts from passive income for three consecutive tax years, the entity will lose its S corporation status. You can see why it is a good idea to have a competent tax adviser.
Deadline for checking the box. There are also certain deadlines within which the business needs to make the election, no more than two months and 15 days from the date of business formation or after the beginning of the tax year you want the election to take effect. The LLC operating agreement should reflect the business form nature of your LLC. So if you and the other members of your LLC want your LLC to be taxed as a partnership, your LLC operating agreement should contain provisions on partnership taxation. It is possible to revoke the election, but you should generally plan in advance to how your LLC will be treated from a tax standpoint.
Small business owners and different forms of taxation when starting a LLC
Now, let’s assume that your business meets all of the criteria for a S corporation and you have a choice between an S corporation and a LLC taxed as a partnership. Taxes loom as a major decision for most new businesses. You shouldn’t let the tax tail wag the dog, but you don’t want to pay Uncle Sam more than you are required to pay.
If you have been in business or worked for a business, you probably have some idea of the many taxes that you have to consider. And when you are talking with your small business lawyer about which business form to adopt for your new company, you should have some idea of what are the major taxes that you and your business are subject to. Take out your calculator and make sure that you keep up to date on changes on the IRS website. You should also talk with your tax adviser because your situation may differ substantially from that of your business partner or investors. There are generally two major kinds of taxes that the new business owner is concerned about: income taxes and social security taxes.
Corporate tax for C corporations. The corporate tax is the tax that a C corporation, a corporation that is not a S corporation, is taxed. The corporation files a corporate return every year and pays taxes on its profits at the corporate level. Let’s say a small business generates taxable income of $200,000. Under current rates, the corporation pays $22,250 in taxes and 39% over $100,000. Then, if the corporation issues a dividend, the individual stockholders will pay taxes at their individual rate. Thus, for the vast majority of small businesses, a C corporation structure is not the way to minimize taxes for the business. There are some circumstances when a small business may want to be taxed as a C corporation and those will be discussed in another blog post.
Income tax for individuals. This is the tax that you pay every year to Uncle Sam and to most states on your net taxable income. If you are the sole member of your LLC, then you pay taxes on your individual return on the net profit of your business. Your business is a disregarded entity for federal income tax purposes. The top rate for individuals if you are in the top bracket is currently 39.6%.
Who’s afraid of FICA? FICA is short for the Federal Insurance Contributions Act and consists of Medicare and Social Security. If you are an employee, you generally are not afraid of FICA because you and your employer split the cost—both of you pay half of the taxes. And your employer withholds the employee’s portion from the employee’s wages. In 2015 the FICA taxes were a total of 15.3%. The employer withholds 6.2% for Social Security and 1.45% for Medicare. The employer also pays its 6.2% for Social Security and 1.45% for Medicare. When the employee makes over $200,000 there is a surtax, which the employee is responsible for. When you are creating your spreadsheet, don’t forget that there is a wage cap (currently set at $118,500) for Social Security. There is no cap for the Medicare portion.
Self-employment tax. If you have worked as an independent contractor and received a Form 1099 from the company that you worked for, then you probably have some idea of what the self-employment tax is. You have to report the income usually on Schedule C of your individual tax return and you pay tax on the net profit, if any. Self-employment tax refers to Social Security and Medicare taxes. The self-employment tax is currently 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. If you think that this sounds familiar, you are correct. It is the same as the FICA taxes. You must pay the entire obligation as there is no employer to help share the cost. You can deduct the amount of self-employment tax that you pay and the deduction will reduce your adjusted gross income and accordingly the amount of income tax you pay. Most taxpayers who are subject to the self-employment tax pay a quarterly estimated tax.
How should the LLC be taxed?
Now you have some idea of the basic taxes that are in play when considering how your LLC will be taxed. In this section, I will go over some of the considerations in deciding how you want your LLC taxed. I will discuss which corporate entity may make the most sense for that particular consideration. And if this tax discussion does not make you want to go to your tax adviser, in the next blog, I will discuss some special circumstances that you will have to look out for and then you will go running to your tax adviser.
Sole owners of the business. If you are the sole owner of a new business, then you generally have two options, to be taxed as a sole proprietorship or a S corporation (you could also elect to be a C corporation, but that would not be common). You may own a piece of real estate and want the LLC for some protection against personal liability. The real estate generates passive income and you would generally leave the default election in place so that the LLC is taxed as a sole proprietorship because of the restrictions on passive income for S corporations. And if you are actively involved in operating a small business, you should consider electing for your LLC to be treated as a S corporation. A single member LLC may include the income and expenses on the member’s individual return. Some of the following discussion would also apply to a single member’s choice whether to elect S corporation treatment.
Multiple owners of the business. Since most of the startups we deal with at Rosten Law PLLC are multi-member LLCs, we are going to concentrate the discussion on LLCs taxed as partnerships and LLCs taxed as S corporations. In some situations, I will distinguish the treatment of LLCs taxed as C corporations (or just plain C corporations). Most of these startups have more than one founder and they are organized as multi-member LLCs. The primary choice for a multi-member LLC is to be taxed as a partnership or taxed as a S corporation. There are many tax considerations, which I will discuss below.
Pass-through entities: toss-up. Both the LLC taxed as a sub S and the LLC taxed as a partnership are pass-through entities. The small business itself does not pay a corporate tax. The business has an employee identification number and the business will file an informational return regardless of whether the startup is taxed as a S corporation or partnership. The owners pay taxes based on their individual tax situation.
Self-employment taxes: significant advantage to S corporation. Possibly the single most important advantage distinguishing a sub S from a partnership is self-employment tax. The ability to reduce social security and Medicare taxes persuades some business owners to choose to be taxed as a S corporation. And if you are an active shareholder in a S corporation, you are allowed to avoid the 3.8% Medicare surtax created by the Affordable Care Act on business profits.
Once the manager in the LLC taxed as a S corporation pays him or herself “reasonable compensation for services rendered,” the remaining amount of the net profit to the company is not subject to self-employment taxes. Good deal, just make sure that you don’t underpay the manager or otherwise the IRS may reclassify all the income as wages. And if they are providing services, they will have to pay self-employment taxes on the entire distribution, subject to the caps mentioned above. If the shareholders provide services to the small business, they will pay the self-employment tax on the amount that they receive. If you think, well, let’s then not pay for services, the IRS can get you for not paying yourself a reasonable salary.
Because of the self-employment taxes, S corporations are better for companies that expect profits to exceed a reasonable salary. Filing as an S corporation will save money for an LLC if the LLC is expecting to show large profits exceeding a reasonable salary for that year.
The self-employment tax savings generally decreases as the size of the company, and the income accordingly, increases. So using some general numbers, if the income for your company is $100,000, the self-employment tax for an LLC will be about $14,000, and the S corporation payroll tax will be about $8,000. If the income is $200,000, the self-employment tax will be about $19,500 and the payroll tax will be about $15,000 and the difference will be about $4,000.
Beware: no unemployment contributions, no unemployment benefits. If your small business is taxed as a S corporation and you are paying yourself a salary and making unemployment contributions, then if you close down the business for some reason, you may be entitled to unemployment benefits. You would have to qualify for benefits (you are not loafing and actually looking for a job). But if your business is taxed as a partnership, you are not paying a salary to yourself and not making unemployment contributions. If your business falls on hard times and you close it down, you would not be entitled to unemployment.
Retention of earnings: toss-up, both S corporations and partnerships lose. This is one major advantage of a C corporation. A S corporation or partnership is taxed regardless of whether any profit is distributed to the owners. In a C corporation, with certain limitations, the shareholders of the corporation pay taxes on their individual tax returns only when they receive a distribution. The corporation pays taxes at the corporate level which in recent years has fluctuated around 35%. If the profit is then distributed to the shareholders, the shareholders in a C corporation would pay tax on the dividend, but not the shareholders in a S corporation or the partners in a partnership.
Allocation of profit or losses: major advantage to partnership. A major advantage of a LLC taxed as a partnership is that the owners may allocate based on the operating agreement income, deductions, losses and credits. Say that one of the members of the LLC has an appetite for tax losses (no one wants to lose money but if there are tax losses the member may be able to use those tax losses to offset gains) and therefore in the operating agreement, the members agree that one member may utilize any losses. A major limitation of the S corporation is that the owners must report their income or losses on a pro rata basis. The owners cannot allocate profits or losses.
One limitation of the members’ ability to allocate losses is that the allocations have “substantial economic effect.” The regulations regarding what constitutes substantial economic effect are detailed and just a little arcane. There is a two-part test to determine whether there is an economic effect and whether that effect is substantial. You can look up some of the guidelines on the IRS website, which has an audit technique guide on partnership allocations. If the purpose of the allocation is simply to avoid taxes, you will not pass the substantial economic effect test.
Which tax regime is better?
The threshold question you want to ask is whether your small business would qualify for S corporation tax treatment. For many clients, that is the end of the story because their startup has something that would make it ineligible for S corporation tax treatment such as one of the partners is a corporation. If the business meets the S corporation criteria, then the next question is whether it is advantageous to the new business to elect to be treated as a S corporation. As we have discussed in this blog, the clear answer is “it depends.” There are advantages and disadvantages to both S corporation tax status and partnership tax status, but the primary driver for those who elect S corporation status is to try to save self-employment taxes. In the next blog, I will write that there are more dimensions to this decision. We will go over some of the rules regarding distributions, redemption of ownership interests, contributions of goods or services, among some other rules that you may want to talk about with your tax adviser. The rules governing taxation of LLCs are complex and a tax adviser is essential to help guide you through the tax maze.