Under California and Federal taxing statutes, which business entity offers the greatest flexibility, and possibly the greatest tax savings?
Obviously there are numerous issues presented to businesses, not the least of which is how to maximize tax savings. One must always weigh all issues presented in choosing a given business entity form. With that in mind, this memorandum will highlight the benefits offered through use of an S corporation and LLC, taking into consideration California Taxes, Federal Self Employment taxes, and formerly proposed regulations concerning limited partnership treatment for certain non-participating members of an LLC with respect to such self employment taxes.
S Corporation v. Limited Liability Company
Limited Liability Company:
· A California operated limited liability company and S Corporation are subject to an annual franchise tax of $800.00. (However, please note that an S corporation is not required to pay the $800.00 fee in its year of incorporation where an LLC must pay the $800.00 in its year of organization)
· In addition, LLC’s taxed as partnerships (Generally, any multi member LLC reports as a partnership) must pay an additional entity level tax based on the total income reportable to California for the tax year. Cal. Rev. Tax Code § 17942.
o Total income is measured by taking the LLC’s worldwide gross income and adding the costs of goods sold, paid or incurred in connection with the business, otherwise known as gross receipts. Cal. Rev. Tax Code § 24271 (Referencing IRC § 61 as controlling). Such tax or fee ranges from $900 – $11,790 as indicated in the following table:
Total Income from all sources
Over $250,000, but less than $499,999
$500,000 or more, but less than $999,999
$1,000,000 or more, but less than $4,999,999
$5,000,000 or more
What does this mean? Basically, it means that a California LLC is taxed on its GROSS RECEIPTS in the manner provided in the table above.
In order to make an election to be treated as an S corporation, the following requirements must be met:
1. Must be an eligible entity (a domestic corporation, or a limited liability company).
2. Must not have more than 100 shareholders.
Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
3. Shareholders must be U.S. citizens or residents, and must be physical entities (a person), so corporate shareholders and partnerships are to be excluded. However, certain tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
4. Must have only one class of stock.
5. Profits and losses must be allocated to shareholders proportionately to each one's interest in the business.
If a corporation meets the foregoing requirements and wishes to be taxed under Subchapter S, its shareholders may file Form 2553: "Election by a Small Business Corporation" with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation's shareholders. If a shareholder resides in a community property state, the shareholder's spouse generally must also sign the 2553.
The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, often, the IRS will accept a late S election.
Some states such as New York require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation.
If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation
Taxation of S Corporation:
· Subject to a California tax of 1.5% net income.
· Net income is generally defined as gross income less any and all costs of doing business.
EXAMPLE: As you may imagine, the $500,000.00 in gross receipts results in substantially less net income. Assume for every $500,000.00 in gross receipts, the company nets $200,000.00 of income. The Company would than owe the state of California 1.5% of the $200,000.00 or $3,000.00.
Side By Side Comparison of S Corporation v. LLC
EXAMPLE 2: Instead of using the above 40% profit margin, let’s determine California tax owed for both an LLC and an S corporation based on a more realistic 15% profit margin Comparison (please remember, LLC franchise tax of $800.00 is in addition to the amounts shown below):
S Corporation Tax
- Clearly, for smaller businesses, there is a distinct advantage to using the S Corporation from a California Tax perspective.
- Please note, however, that as sales increase, the LLC Tax owed to California is capped at $11,790.00. While such amount is assumedly raised pursuant to inflation on a regular basis, the tax owed by an LLC will always be capped, that is never subjecting the gross receipts to a percentage tax.
- By contrast, there is no cap on the amount of net income subject to the 1.5% California S corporation tax.
Treatment of Self Employment Taxes
The self employment tax is an additional tax of 15.3% levied on income up to $94,200.00 and 2.9% on all income in excess of $94,200.00. In general, the measure of tax is all income derived from a trade or business. When dealing with pass through entities, however, such distinction is blurred, and the tax code does little to clarify.
An S corporation is a pass through entity. Consequently, all income of the corporation is passed through to the shareholders on their K1’s and reportable on their respective individual returns. When, however, the shareholder is actively involved in the trade or business producing the income, some portion of that income is subject to self-employment tax.
Under the rules governing S Corporations, only amounts received as compensation for services rendered are subject to the self-employment tax. Accordingly, only those amounts specifically paid as a salary are subject to self-employment tax, leaving all other income passed through free from self employment tax liability.
After abuses were discovered, the IRS began to closely scrutinize salaries paid to S Corporation Shareholders to determine whether they were reasonable. Generally the facts and circumstances surrounding the business control; however, some guidelines are:
- Salaries generally paid for comparable positions; and
- Amount of retained earnings that are passing through to the shareholder as a “dividend;”
Once a S corporation shareholder receives his/her “reasonable salary,” all other amounts (referred to as both dividends and distributions) are reportable on his or her individual return as ordinary income, and subject only to federal and state income tax rates. Clearly an S Corporation with substantial earnings could save a tremendous amount of tax dollars by paying only a “reasonable salary.”
Limited Liability Companies
The self employment tax treatment of members of LLC’s is a gray area of tax law. One generally accepted rule states:
- Managing members are taxed like general partners, that is his or her entire distributive share is subject to self-employment tax, not just amounts received as compensation for services;
The treatment of non-managing members, however, is ambiguous at best.
In 1997, the IRS issued proposed treasury regulation 1.1402(a)-2. During this time, there was disagreement as to the treatment of Limited partners in partnerships; therefore, Congress refused to allow the IRS to finalize any rules regarding non-managing members of LLC’s believing it was within Congress’s purview to issue such rules.
As is generally the case, Congress failed to issue guidelines, and the proposed regulation was obviously never codified. However, it does offer the only administrative guidance regarding treatment of non-managing members for self employment tax purposes.
Basically, Treas. Reg. 1.1402(a)-2 treated members of an LLC as limited partners unless they met one of the following tests:
- They have personal liability for debts or claims against the partnership or LLC;
- Obviously this effectively removes professionals from garnering beneficial self employment treatment;
- They have authority to contract on behalf of the partnership, or LLC; or
- They participate in the partnership’s trade or business for more than 500 hours during the partnership’s tax year.
Consequently, while not entirely clear, a non-managing member not meeting any of the above criteria could receive his or her distributive share free from self employment tax liability.
Possible Safe Harbors for Failing one of the Above Conditions:
If an LLC member fails the limited partner test because that member participates in a nonprofessional LLC for more than 500 hours during the tax year, Proposed Treasury Regulations section 1.1402(a)-2(h)(4) allowed that member to be taxed as a limited partner/non-managing member for self employment tax purposes if he or she:
(1) owns only one class of interest; and
(2) if, immediately after acquiring the interest, the member has rights and obligations identical to those of the other members who are already classified as limited partners and who own a substantial (i.e., at least 20%) continuing interest in that class of interest.
In addition, Proposed Treasury Regulations section 1.1402(a)-2(h)(3) allowed an LLC member of a nonprofessional LLC who fails one or more of the limited partner tests, but who holds more than one class of interest, to be treated as a limited partner with respect to a particular class of interest if, immediately after acquiring the interest, the member has rights and obligations identical to those of the other members who are already classified as limited partners and who own a substantial (i.e., at least 20%) continuing interest in that class of interest.
All references researched seemed to indicate substantial confidence in taking the positions stated above when filing a return for a non-managing member of an LLC. However, there exists no clear guidance on how the IRS will treat such positions if audited. So, taxpayer must still be advised of possible risks.