Facts about LLC’s and why you should change to an S-Corporation in 2018!
First, a quick reminder and review of the most common business entities and structures.
- A sole proprietorship is the simplest form of business entity. Taxpayers do not file a separate tax return and instead, business income and expenses are reported on a federal form 1040, Schedule C. These entities pay for self-employment taxes.
- A partnership is an association of two or more persons to carry on a business and can take different forms (like limited or general partnerships). A partnership files a separate return, a federal form 1065, and passes income and losses to the individual partners who are responsible for reporting that information on their individual tax returns.
- A Limited Liability Company (LLC) is a hybrid entity that offers the option to be taxed as a partnership or a corporation.
- A Single Member Limited Liability Company is an LLC with a single member, typically treated as a “disregarded entity” for federal tax purposes. That means there’s no separate tax form and income and expenses are reported on a Schedule C, just as with a sole proprietorship. These entities pay for self-employment taxes.
- A C corporation is what most people think of when it comes to business. A C corporation files a federal form 1120 and pays any tax due. Shareholders also pay tax at their individual income tax rates for dividends or other distributions from the company (this is where the term “double tax” comes from).
- A Professional or Personal Service Corporation is a corporation for certain occupations – typically service professions like lawyers, doctors, and architects.
- An S Corporation is a corporation with tax treatment similar to a partnership. An S corporation files a federal form 1120-S which passes most items of income or loss to shareholders who are responsible for reporting that information on their individual tax returns.
The two most common business structures are LLC and the S-corporation entities. We will discuss the similarities, differences in ownership and formalities, differences in management, other differences between S corps and LLS’s, and other disadvantages of the LLC.
Whether you’re just starting a business or thinking of changing your business structure, a common first step is comparing LLC vs. S corp. While a limited liability company and S corporation share many qualities, they also have distinct differences. Once you get familiar with the details you will probably come to the conclusion that the S- corporation is best suited for your needs.
LLCs and S corps have much in common:
- Limited liability protection. With both, owners are typically not personally responsible for business debts and liabilities.
- Separate entities. Both are separate legal entities created by a state filing and registration.
- Pass-through taxation. Both are typically pass-through tax entities, and while S corps must file a business tax return, LLCs only file business tax returns if the LLC has more than one owner. With pass-through taxation, no income taxes are paid at the business level. Business profit or loss is passed-through to owners’ personal tax returns. Any necessary tax is reported and paid at the individual level.
- Ongoing state requirements. Both are subject to state-mandated formalities, such as filing annual reports and paying the necessary renewal registration fees.
Differences in ownership and formalities
Ownership. The IRS restricts S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:
- LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
- Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders.
- S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. This is not the case for LLCs.
- LLCs are allowed to have subsidiaries without restriction.
- Ongoing formalities. S corporations face more extensive internal formalities. LLCs are recommended, but not required, to follow internal formalities.
- Required formalities for S corporations include: Adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
- Recommended formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.
Differences in management
- Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership. If run by managers, the LLC more closely resembles a corporation; members will not be involved in the daily business decisions.
- S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage daily business affairs.
Other differences between S corps and LLCs include: These are the most important factors in deciding between the LLC and the S-corporation business structure.
- Existence. An S corporation’s existence is perpetual, but some states require LLCs to list a dissolution date in the formation documents. Certain events, such as death or withdrawal of a member, can cause the LLC to dissolve.
- Transferability of ownership. S corporation stock is freely transferable, as long as IRS ownership restrictions are met. LLC membership interest (ownership) typically is not freely transferable—approval from other members is often required.
- Self-employment taxes. S corporations may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary. FICA taxes are withheld and paid on that amount. Corporate earnings after payment of the salary may be able to be treated as unearned income that is not subject to self-employment taxes.
Other Disadvantages of an LLC
- Profits are subject to Social Security and Medicare taxes. For an LLC that is disregarded for tax purposes, there can be the disadvantage that all earned income is subject to the self-employment tax, unlike in an S corporation in which some money can be taken out as salary and some as dividends. However, the LLC can opt to be taxed as a corporation and then opt to be taxed as an S corporation.
- Owners must immediately recognize profits. Unless an LLC elects to be taxed as a corporation, profits are automatically included in a member’s income. On the other hand, a C corporation does not have to immediately distribute profits to its shareholders as a dividend. This means that shareholders in a C corporation are not always taxed on the corporation’s profits.
- Personal liability for payroll taxes. The owners of an LLC that is taxed as a disregarded entity (like a partnership or proprietorship) can be personally liable for payroll taxes that are not paid by the company. Shareholders of a corporation would not be liable for these taxes unless they were officers or directors.
- Unfavorable state tax rules and fees. In some states, an LLC must pay higher taxes and fees than would a corporation that generated the same revenues.
- Fewer fringe benefits. Employees of an LLC who receive fringe benefits, such as group insurance, medical reimbursement plans, medical insurance and parking, must treat these benefits as taxable income. However, C corporation employees who receive fringe benefits do not have to report these benefits as taxable income.
What should LLCs do in preparation of the new IRS partnership tax audit and assessment rules?
As of December 31, 2017, the IRS will require all entities taxed as partnerships to pay for imputed taxes on partners for prior tax years at the partnership level. Most LLCs elect to be treated as partnerships for tax purposes. These LLCs and other partnerships should:
- Ensure their operating agreement provides that former members are required to indemnify the company for assessed taxes paid by the company in connection with imputed underpayments of taxes by members; and
- Consult with legal counsel and accountants for advice on their ability to opt out of the new rule and whether an opt-out is appropriate;
- Prepare to comply with the new rule and select a Partnership Representative.
New Partnership Audit Rules
Beginning December 31, 2017, the IRS will administer new laws (26 USC §6221) governing audits and assessments of entities taxed as partnerships. A partnership, for federal tax purposes, is any company that elects to be taxed as a partnership, has more than one partner or member and is not a corporation. The new law applies to all entities taxed as partnerships, which includes most LLCs. It states:
“Any adjustment to items of income, gain, loss, deduction, or credit of a partnership … (and any partner’s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty … [that] relates to an adjustment to any such item or share shall be determined, at the partnership level….”
You have heard and learned about the disadvantages of the LLC’s and the new tax law changes coming in 2018. If you are currently an LLC you may want to think about changing to an S-corporation structure. If you are a new business owner you need to start out on the right foot and set a strong foundation for success with the correct business structure!
It is very clear that a new business owner needs to start an S-corporation business structure and file an s-corporation tax return to gain the most tax-favored advantages. For more information and whether this might apply to your particular situation, please feel free contact the author.
RMH Tax & Financial Advisors, Inc.
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