“Which is better: a Limited Liability Company or an S corporation?” This common question blurs two distinct concepts: how an entity organizes for corporate governance purposes and how an entity classifies itself for tax purposes. Because the vast majority of small business are LLCs, the more appropriate question is “what tax election is best for an LLC?” The answer, of course, is it depends.
A common misconception is that only entities that organize as corporations can elect S corporation tax status. In fact, both corporations and LLCs can elect S corporation status. In addition, an LLC can be taxed as a disregarded entity, a partnership, or as a C corporation. Subject to a few restrictions, an LLC’s members can simply elect the status that works best for them. If members make no election, an LLC with one member will default to disregarded entity status and an LLC with two or more members will default to partnership status.
Given the similar pass-through nature of partnership and S corporation tax rules, many small business owners question which tax designation is best for them. This article will focus on three key issues that members should evaluate before electing either partnership or S corporation tax status.
For 2017, FICA taxes total 12.4% of an individual’s first $127,200 of earnings and 2.9% of all earnings (15.3% total). There is an additional Medicare tax of 0.9% for high earners ($200,000 single and $250,000 joint).
Under the partnership tax rules, members that participate in the business will pay 15.3% FICA taxes on both wages (called guaranteed payments) and net earnings distributions (excluding earnings from rentals, interest, dividends, and capital gains). Under the S corporation tax rules, members pay 15.3% FICA taxes only on the wages the member receives from the entity but not on any net earnings distributions. The catch is that the IRS requires that a member’s wages must be “reasonable.”
Example: Jack is the sole owner and employee of an LLC that has $125,000 in earnings after paying all expenses except for Jack’s wages. Under the partnership tax rules, Jack will pay $19,125 in FICA Taxes on the entire $125,000. Under the S corporation tax rules, if Jack sets his “reasonable” wages at $60,000 and takes the remaining $65,000 as a distribution, Jack pays only $9,180 in FICA taxes on his wages and avoids paying $9,945 in FICA taxes on the $65,000 distribution.
Allocation of Tax Attributes / Distributions
LLCs that elect S corporation or partnership tax status must allocate their tax attributes and earnings amongst their members. Under the S corporation rules, an S corporation must allocate its tax attributes and make distributions proportionately based upon the owners’ ownership interests. On the other hand, LLCs that elect partnerships tax status can disproportionately allocate tax attributes and distributions. Accordingly, if members want to allocate profits, losses, tax credits, or other tax attributes disproportionately, the members must elect partnership status for the LLC.
Tax Basis Rules / Tax Free Distributions / Losses
A member’s tax basis in the member’s ownership interests is generally the amount of the member’s capital investment. Under either a partnership or S corporation tax election, a member can only deduct the member’s share of losses or receive tax-free distributions to the extent of the member’s tax basis in his or her ownership interest. Under the partnership tax rules, a member can include the member’s share of the LLC’s debts in the tax basis of his or her ownership interest. Conversely, under the S corporation tax rules, a member cannot include the member’s share of the LLC’s debt in the tax basis of his or her ownership interest, even if a member personally guarantees the LLC’s debt.
Example: Jack and Jill form an LLC and each contribute $100,000 for their ownership interests. The LLC obtains a loan for $1,000,000 to purchase real estate. Under the partnership rules, Jack and Jill would each have a basis in their ownership interests of $600,000. Under the S corporation rules, Jack and Jill would each have a basis in their ownership interests of $100,000. Accordingly, the partnership tax rules provide Jack and Jill the ability to utilize an additional $500,000 in losses or tax-free distributions.
There are many factors in addition to the ones listed above to consider when determining your LLC’s tax status. Accordingly, you should seek the guidance of a tax advisor to determine the classification that works best for you and your business.
Additional information on small business planning can be obtained from the Closely-Held & Family Owned-Business Team at Conway, Olejniczak & Jerry.