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ОглавлениеS-C-L-L-C!
S-C-L-L-C!
It sounds like a college cheer, something you would hear at a football game. But for entrepreneurs and investors it is more often not a chant but a rant:
S Corporation? C Corporation? Limited Liability Company? What should I do?
By the end of this chapter you will further appreciate certain key differences and will be much closer to making the right choice. Armed with the knowledge gained in this book, you and your advisors will carefully consider the options and select the right entity.
It shall be so.
In our last chapter we explored some of the differences between entities. In this section we will build upon that foundation to erect several structures for your consideration. Please note that we have not included limited partnerships in this discussion. The reason is not due to any unfavorable prejudices against LPs. As in Jim’s case in the last chapter they have great utility. However, the LP requires a corporate or LLC general partner for complete asset protection and thus the filing and maintenance of two entities instead of just one as with an LLC.
As well, aside from that difference, LLCs and LPs are similar and so for ease of discussion we will utilize the more popular of the two—the LLC.
Just as with personal ads, where you need to get to the liking of pina coladas on the beach and disliking of mean people very quickly, the following are key distilled likes and dislikes about corporations and LLCs:
C Corporations
Likes: No limits on shareholders and classes of stock. Lower tax rates on first earnings allowing for future expansion. The best entity for going public. Maximum fringe benefits allowed. Free transferability of stock.
Dislikes: Double taxation on profits, once at the corporate level, next at the shareholder level. Fixed allocation of profits and less flexible management structure. (The same is true for S corporations.)
S Corporations
Likes: Efficient tax treatment. The best entity for minimizing payroll taxes. Charging order protection for corporate shareholders (both S and C) with Nevada corporations.
Dislikes: Must apply for flow-through tax treatment. Can inadvertently lose flow-through tax treatment (see Case No. 6 ahead). Limits on shareholders and classes of stock. No flow-through of business debt. Fixed allocation of profits.
Limited Liability Companies
Likes: Excellent asset protection via charging order rules in Nevada and Wyoming. Flow-through of business debt. Flexible allocation of profits. Flexible management structure.
Dislikes: Difficulty of minimizing payroll taxes. Extra state taxes in California. Newer entity with less case law to interpret future events. Less free transferability of interests than corporate stock (some may see this as an advantage).
Using these guidelines, let’s apply them to the two main reasons for forming an entity:
1. To operate a business
2. To hold assets
Operate a Business
When it comes to choosing the right entity for operating a business several factors must be considered.
While both corporations and LLCs offer limited liability protection, that issue will be fully discussed in the next section. For now, in the business context, the first issue is:
Payroll Taxes
Salaries paid to employees (including owner-employees) are subject to FICA and Medicare taxes, otherwise known as payroll taxes. (For the current taxable limits visit www.corporatedirect.com/accounting.html.) At 15.3 percent of payroll, these taxes will be one of the largest expenses a business will have. If you are savvy you have not bought into the argument that these taxes are “only” 7.65 percent of payroll. If you own the business you are paying both halves of that, or a whopping 15.3 percent on all of your payroll. Given that our Social Security system is near bankruptcy and that citizens under forty may never see any of the promised benefits, it becomes important to consider how to best minimize payroll taxes.
In a C corporation, which features a double tax on profits, it makes sense to pay as high a salary as possible in order to avoid the tax on dividend distributions. But with salaries come payroll taxes.
In an LLC, with its flow-through tax treatment, profits flow through to the owners. The problem is that at this writing, under IRS guidelines all such profits, whether taken as a salary or not, are subject to payroll taxes for those LLC members active in the business.
In an S corporation you can pay yourself a reasonable salary, on which you pay payroll taxes. Profits after salary can be flowed through to the owner without payroll taxes. (Please note that an LLC can elect to be taxed as an S corporation and achieve this benefit.)
For example, Brendan makes $200,000 a year in his pool cleaning business. As a single-member LLC, he would pay over $18,000 in payroll taxes on the entire $200,000 profit. If Brendan used an S corporation and paid himself a $72,000 a year salary and flowed the rest through as profits without payroll taxes, his payroll taxes would be $11,000 per year. As such, Brendan could save $7,000 a year, year in and year out, by using an S corporation over an LLC. Who says choice of entity isn’t important?
Business Debts
An S corporation’s business debts cannot be utilized by the shareholders unless they have personally guaranteed the debt. Of course, a personal guarantee means that if the corporation can’t pay the debt then you are obligated as an individual to repay the money. It is best to avoid personal guarantees if possible (see Chapter 10 on business credit). In an S corporation, when the company takes on debt without shareholder guarantees the shareholder’s tax basis does not increase. As a result, more distributions are subject to tax.
In an LLC, the members get the benefits of business debt, whether guaranteed or not. An example helps to explain this advantage.
Lisa, Lyn and Lovella are equal owners in a children’s clothing business. Their LLC has good credit and is able to borrow $600,000 without the need for personal guarantees. The loan has the effect of increasing each owner’s tax basis by $200,000. Because distributions are taxed only when they exceed an owner’s basis, this means that Lisa, Lyn and Lovella can each receive $200,000 in profit distributions tax free from the LLC. The company’s borrowings have improved their tax situation.
By contrast, in an S corporation, unless a personal guarantee was signed, Lisa, Lyn and Lovella would not receive such a tax benefit. The $600,000 loan would not provide them with the tax benefits in an S corporation as it would through an LLC. Be sure to work with your advisors to maximize this benefit.
Fringe Benefits
While in recent years certain benefits such as health insurance premiums have been granted as write-offs for all entities the best entity for fringe benefits is still the C corporation.
Like other entities, a C corporation can write off employees’ health insurance premiums. The company can also provide group term life insurance and medical reimbursement plans for its employees at company expense. These benefits are tax-free to the employees. By contrast, an S corporation cannot provide employees key fringe benefits such as medical reimbursement and group term life insurance plans on a tax free basis.
For more information on these matters see Tom Wheelwright’s book Tax Free Wealth (BZK Press, 2012)
Owner Flexibility
In both a C corporation and an LLC there is flexibility of ownership. Shareholders in a C corporation and members of an LLC can be individuals, trusts, corporations, foreign citizens, aliens, Martians, whatever. There is no such flexibility in an S corporation, as our next case illustrates.
Case No. 6: Burnham’s Baked Hams
Jeanne, Elizabeth, and Bernie were ready to enter the baked ham business. They had done their homework and felt they knew their niche and could succeed in it. Elizabeth had done quite a bit of studying. Being cautious by nature she knew they had to form a corporation to protect themselves. Jeanne was more concerned about how the money flowed. If they were going to form a corporation it had to be an S corporation. She did not want to pay a double tax on profits above salaries. Bernie was a sunny optimist. He just wanted to be in business making money selling his delicious baked hams. He left the details to Jeanne and Elizabeth.
After incorporating they obtained their EIN (Employer Identification Number—their taxpayer ID number) from the IRS. With that they filed Form 2553 within forty-five days of incorporating in order to qualify for S corporation status. They issued themselves each 100,000 shares and were one-third equal owners of Burnham’s Baked Hams, Inc.
Right off the bat, in their first year of business, they were successful. Bernie baked a tasty ham. They each took a salary of $40,000 per year. Self-employment taxes were paid on those salaries. At the end of the year there was a profit of $120,000. They each received a dividend of another $40,000.
Because they were an S corporation, the $120,000 in profits was not taxed as a dividend as in a C corporation. Instead, it flowed through the corporation without tax to their individual returns. And, unlike an LLC, where the flow-through could be subject to self-employment taxes, the dividends came to them free of Social Security and Medicare taxes.
Their S corporation was a beautiful thing. Ordinary income and payroll taxes were paid on salaries and no payroll taxes were paid on profits. Bernie was happy, as always, Jeanne was pleased to be getting her money, and even ever cautious Elizabeth was content.
As always, an S corporation can work wonderfully until you break some arcane rule that, bingo, automatically terminates your tax status.
Burnham’s Baked Hams, Inc., was expanding rapidly. Bernie had negotiated a very large and favorable deal for distribution throughout Canada. In order to get the deal done, Basil Lee, a Toronto-based distributor, wanted to receive 5 percent of the company. Bernie and, surprisingly, prudent Elizabeth were for this arrangement. But Jeanne did not want Basil in the company. She did not like him or trust him. Still, the deal would be huge for their company. So a compromise was reached whereby the corporation would authorize two classes of stock—one class of common voting shares that could elect the board of directors and a second class of nonvoting preferred that would not elect any directors and thus have no say in management. Basil was then issued preferred shares equal to 5 percent of the total authorized shares (common and preferred together) but he had no power to control the company, which is how Jeanne wanted things.
Elizabeth had her own legitimate concerns. She did not like holding the company shares in her own name. There were too many unethical potential creditors, too many vexatious potential litigants, just too many questionable people out there for her liking. She knew her views were completely justified and wanted to have the shares held by an irrevocable spendthrift trust where they would be safe from the claims of others. She formed an irrevocable trust to hold the shares and transferred them from her name to that of the trust.
Sometime thereafter the company received a notice from the IRS. Their S corporation status was terminated.
Why?
Because Burnham’s Baked Hams, Inc. had the following:
1. A non-U.S. shareholder (Basil the Canadian)
2. More than one class of stock (preferred for Basil and common for the others)
3. A trust as a shareholder (Elizabeth’s trust).
Any one of those three is enough to terminate S status. And that is how Jeanne, Elizabeth, and Bernie learned the problem with an S corporation. Things can be going along just fine when through some unforeseen transaction (a shareholder unwittingly sells to a nonresident alien, for example) you lose your tax status. And when that happens you become a C corporation and cannot be taxed as an S corporation for five years.
