S-corp vs. LLC: Allocation of income and losses

As you have now discovered, there are a number of differences between S-corporations and LLCs. S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to follow are far more relaxed.  There are also differences in the taxes and fees that they have to pay to California, and the types of compensation that the owners of each can take. The amount of flexibility you have in allocating income and losses between the owners is also a key difference.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage.  Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation's taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

If you have questions about the tax differences between S-corporations and LLCs, or if you would to talk about the requirements necessary in order to have non-proportional allocations in your LLC, please send me an e-mail.

S-corp vs. LLC: Income

In last week's blog, we discussed how California taxes S-corporations and LLCs differently.  In this blog, we will be discussing the differences in how the owner's compensation is classified.

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www.nanohealthtechnology.com

The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. While they will be discussed in more detail in a future post, it is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.

On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways.  The first, like LLC members (owners), is through ownership distributions.  These are withdrawals of the business' profits.  The second method, which is not available to LLC members, is through a salary.  In fact, an owner-employee of an S-corporation is required to take a "reasonable salary" before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business.  The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions.  This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business.  You could, for example, take out $20,000.  However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.

An S-corporation's net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.

Regardless of whether your business is structured as an LLC or as an S-corporation, the business's profits are passed through to the owners and subject  to income taxes.  They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.

If you would like to know more about the differences between S-corporations and LLCs and how it can affect your taxes, please send me an e-mail.

S-corp vs. LLC: CA Minimum Taxes

Besides the formalities that S-corporations have to observe, there are a few other differences between S-corporations and LLCs.  One difference that will affect your bank account is how California assesses taxes.

Image borrowed from www.alliancetrustcompany.com

The amount of California taxes that an S-corporation will pay is based upon its net income.  An S-corporation pays the greater of $800 or 1.5% of its net income.

An LLC, on the other hand, pays $800 of California taxes and may be assessed an LLC fee based upon its revenue.  The table below shows the LLC fee for the various revenue ranges.

Revenue	LLC Fee
$0 - $249,999	$0
$250,000 - $499,999	$900
$500,000 - $999,999	$2,500
$1,000,000 - $4,999,999	$6,000
$5,000,000 +	$11,790

Therefore, whether an S-corporation or an LLC makes more sense for your business (based purely on the amount of taxes you will pay to California) depends on what you expect you revenues to look like compared to your net income.  Lets look at a few examples.

Example 1

You expect your business to have $600,000 of revenue but only $60,000 of net profit.  In this case, it makes more sense to operate as an S-corporation.  As an S-corporation you would be paying $900 in taxes to California ($60,000 x 1.5%).  However, as an LLC you would pay $3,300 ($800 of taxes plus a $2,500 LLC fee).

Example 2

You expect your business to have $900,000 of revenue and $300,000 of net profit.  In this example, it makes more sense to operate your business as an LLC.  As an LLC, you will be paying $3,300 to California ($800 of taxes play a $2,500 LLC fee).  However, as an S-corporation you would be paying $4,500 in California taxes ($300,000 x 1.5%).

If you would like a further understanding of the tax differences between LLCs and S-corporations, please send me an e-mail.

Can You Own an LLC By Yourself?

Sometimes the number of owners a business has affects what types of entities it is allowed to operate as.  While a corporation can have one or more owners (shareholders), a partnership by definition must have two or more owners.  An LLC can be thought of as a hybrid between corporations and partnerships, so can it have only a single owner (member)?  It depends.

Image borrowed from www.corporatedirect.com

The federal government's position changes depending upon how an LLC elects to be taxed.  LLCs have the option to be taxed as either a corporation or a partnership, but the default rule is that LLCs are taxed as partnerships.  If a single-member LLC elects to be taxed as a corporation, then the federal government will recognize the LLC as a corporation. However, if a single-member LLC elects to be taxed as a partnership, then the federal government will treat the LLC as a "disregarded entity".

The federal government essentially creates a legal fiction that the disregarded entity does not exist. It looks through the disregarded entity and attributes all of the entity's actions to its owner.  The owner is required to report the entity's income on its own tax return.

California, however, does not treat a single-member LLC any differently than any other LLC.  The LLC is required to file its own tax return for California.  In addition, because LLCs are created under state law, a single-member LLC has all of the same legal protections that any other LLC would have, such as limited liability protection.  If you would like a better understanding of a single-member LLC's legal rights, I would recommend talking to a business law attorney.

If you have any questions regarding how a sigle-member LLC is taxed, please send me an e-mail.

Is an LLC the Right Choice for You?

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

Image borrowed from bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a "minimum tax" and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 "Articles of Organization of a Limited Liability Company (LLC)".  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to "pierce the corporate veil" and remove your LLC's limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing them in detail in future posts.  In the meantime, if you have any questions about LLCs please send me an e-mail.

Built-in Gains Tax

If you have been operating your business as a corporation but are now contemplating making the S Election, make sure you speak to a tax advisor about how the Built-in Gains Tax could potentially impact you.

As I discussed in the blog post "Is an S-Corporation Right for You?", an S corporation has all the traditional benefits of a C-Corporation (or what you typically think of as a corporation) including limited liability protection, but like a partnership the owners only have to pay income taxes on the distributed profits once.

The S Election could be made right after the business is incorporated, in which case you do not have to worry about the Built-in Gains Tax. However, the election can also be made years after the corporation has been formed.  In that event, it is important that you understand when the Built-in Gains Tax is triggered and how it operates because it could impact the business decisions you would otherwise make.

The Built-in Gains Tax may also apply if an S-corporation ever acquires assets from a C-corporation in a tax-free transaction.

The purpose of the Built-in Gains Tax is to prevent the shareholders of a C-corporation from converting to an S-corporation with the intend of avoid the tax consequences that would otherwise apply in a liquidation.  In other words, the Built-In Gains Tax is intended to prevent owners of a C-corporation from avoiding the taxes they would otherwise have to pay when shutting down or selling off all or part of their business by converting to an S-corporation.

Essentially, when converting to an S-corporation, the corporation must look at the assets it owned prior to the S Election taking effect and determine if those assets have appreciated in value (a formal appraisal is highly recommended).  If they have, the amount of appreciation on each asset will be known as the net unrealized built-in gain.  If the S-corporation then, within the applicable time period, sells that asset, the corporation (not the shareholders) must pay the Built-in Gains Tax, which is equal to the top marginal corporate tax rate (currently 35%), on the net unrealized built-in gain.

The applicable time period is currently 10 years, but shorter time periods apply to conversions that occurred in prior years.  If the S Election took effect in 2009 or 2010, then the applicable time period is 7 years.  If the S Election took effect in 2011, 2012, or 2013, the applicable time period is 5 years. It is always possible that new legislation will be enacted shortening the applicable time period again, so please talk to a trusted advisor if you are concerned about how the Built-in Gains Tax might affect you.

If you have questions about the Built-in Gains Tax, please send me an e-mail.

Is an S-Corporation Right for You?

You like the idea of forming a corporation because you want the limited liability protection, but the high cost of being taxed twice on the same income is very unappealing.  So then you thought about operating your business as a partnership so that your share of the business income will flow through to you, but the risk of being sued due to the actions of others is just too great.  A limited partnership doesn't work for you either because you want to be the one actively managing your business, not just an investor.  What other options are available to you?  One option is an S-corporation.

Image borrowed from Pacific
Associates Corporation

Every S corporation starts off as a C corporation, or what you may think of as a "regular corporation."  Then, the corporation will make an election, commonly referred to as an S Election, to be taxed under Subchapter S of the Internal Revenue Code. Basically, what this means to you is that taxes are paid at the owner-level rather than at the business-entity level, just like with partnerships.  But unlike partnerships, because an S-corporation is still a corporation it has the benefit of limited liability protection.

The S Election is made by filing Form 2553 with the Internal Revenue Service.  Once the election is made with the IRS, S corporation status is automatically recognized by California.  The election may be filed anytime during the year prior to when the election is to take effect, or within the first 2 months and 15 days of the year in which the election is to take effect.

However, there are restrictions on what corporations can be S-corporations.  First, the corporation must be incorporated within the United States.  Next, all the shareholders (owners) must be either individuals, estates, and certain types of trusts.  An S corporation may not have partnerships, corporations, or non-resident aliens as shareholders.  Additionally, an S corporation may not have more than 100 shareholders, and there can only be one type of stock issued.  The reason there can only be one class of stock issued is that all the shareholders must have the same rights in the corporation.  Finally, an S-corporation is not allowed to engage in certain types of business, such as finance or insurance.  If any of these restrictions are violated, the S-corporation status will be revoked.

S corporations have to comply with the same formalities that their C corporation counterparts do. Some of these formalities are:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

However, this is not an exhaustive list and you should talk to a corporate law attorney to see what other formalities have to be observed.

In future blog posts, we will discuss in more detail the distinctive characteristics of S-corporations and specifically how they differ from other types of entities.

If you would like to talk about the unique tax rules that govern S-corporations and how they may impact your business, please send me an e-mail.