This is one of the most frequently asked questions we get from small business owners. Like many questions, the answer is, “It depends!”. We will explain a few of the nuances, but it generally boils down to the following three questions:
- Are you forming an entity to invest or to operate a business?
- Do you have multiple owners, and will you need to make special allocations to any of them?
- How likely will you ever want to distribute appreciated assets from the business to an owner?
Are you forming an entity to invest or to operate a business?
Unlike S corporations, the net income from an LLC taxed as a disregarded entity (“DRE”) or as a partnership that is operating a trade or business is subject to 15.3% self-employment tax (“SE tax”) of 15.3%. SE tax is in addition to regular income tax and applies whether there are one or multiple owners. If you receive significant wages or self-employment income from other sources, this may help reduce this impact. Generally, ownership of real estate activities by an LLC is not subject to SE tax unless significant services are provided in connection with the operation of the real estate, such as a hotel.
Therefore, we recommend using LLCs to own real estate or other investment assets and S corporations to own operating businesses. However, this depends on your circumstances and should be discussed with your attorney and CPA.
While the earnings of an S corporation are not subject to SE tax, shareholders must be paid reasonable compensation for work done for the company and will receive a Form
W-2 to report the wages. Failure to pay reasonable compensation to shareholders could result in all S corporation income being subject to SE tax. So, while there is an opportunity for an S corporation business to save SE tax if reasonable compensation is less than the business’s total net income, these savings are partially offset by the additional cost and inconvenience of preparing payroll and filing a business tax return.
Do you have multiple owners, and will you need to make special allocations to any of them?
S corporations are generally our entity of choice when owning operating businesses. However, tax attributes such as income, losses, other separately stated items, and distributions must be allocated to the owners based on their proportionate share of their stock. Special allocations are not allowed in an S corporation. If an S corporation is deemed to have a second class of stock, the S election is terminated. The S corporation changes from a pass-through entity, where one level of income tax is paid at the individual level, to a C corporation, which must pay tax at the corporate level in addition to the tax paid at the shareholder level on distributions. Therefore, if you need to specially allocate items among owners, an LLC taxed as a partnership will likely be your choice.
Other structuring alternatives can allow you to have the best of both worlds if the size of the transaction and the net income justify the additional cost of multiple entities.
How likely will you ever want to distribute appreciated assets from the business to an owner?
Although rare, it sometimes happens with real estate and when assets are sold. With the proper planning and documentation, LLCs taxed as partnerships can distribute assets tax-free to the owners or other partnerships in exchange for an interest in that partnership.
In other words, an interest in one partnership can be exchanged for an interest in another partnership tax-free. These are highly complex rules and should only be attempted with assistance from your attorney and CPA. Generally, the distribution of an appreciated asset from an S corporation is treated as a deemed sale, and tax must be paid on any gain recognized. Distributing an asset from an S corporation to a 100% shareholder is a deemed sale. Since this distribution typically only happens with real estate, this is another reason to use LLCs to hold real estate.
While the answers to these questions help you decide whether your business should be an LLC or an S corporation, your unique circumstances are equally important. Let us help you start with a strong foundation by identifying the right entity structure for your business.
