My question is why do people run their corporations as an LLC over an S-Corp?
I have read quite a bit on S-Corps and LLC’s and see no benefit to an LLC over an S-Corp. An S-Corp can have only one owner where as an LLC needs to have multiple ‘members’. Some states won’t even recognize the LLC if it only has one ‘member’ and will pierce the corporate veil (i.e. liability protection) to revert it back to a parntership (which other that the liability portion, is the only difference between an LLC and a partnership).
S-Corps can disburse their earnings in the form of Salaries and pass through income. The pass through income is not subject to the 15.3% Social Security / Medicare tax. ALL of the earnings from an LLC are subject to the ‘self-employment’ tax.
S-Corps are corporate entitities just like LLC’s and have exactly the same liability protection afforded all Corporations they are just taxed differently (read no double taxation on dividends like a C-Corp).
There are some negatives to S-Corps that LLC’s don’t have and that is that only individuals can have ownership in an S-Corp so if you have companies investing in your business then it’s not an option. LLC’s also have a higher basis to deduct losses than an S Corp unless you finagle the money and lastly an S-Corp has to pay all of the shareholders the same based on their ownership in the company unlike an LLC which can have a ‘member’ who ‘owns’ 50% but only makes 25% of the income, an S-Corp divies up the pass through income based stickly on the shares owned.
So, why do people pick an LLC - Am I missing a valuable bit of information that would swing it the other way?
Didn’t you answer your question in the last paragraph. You did forget the lack of formality of the LLC (no BOD meeting required)
With the flexibility, why not a LLC. In the state of Fl. it cost the same.
hey tninvestor,
i live in florida and from what I seen, if youu have an s corp you gotta pay quarterly taxes for the employees. I know cuz a friend of mine is using it for his contracting web testing business. Yet an LLC has more flexibility by passing all down to the memberships wtihout double taxation. The scorp gets taxed, and then the emploeys. The LLC is simply a pass thru entity. If I am wrong in any part, anybody please correct me.
steve
The S-Corp is a pass through entity in exactly the same way as the LLC (i.e. the entity is not taxed - only the individuals that receive income are taxed). The S-Corp does require you to pay a salary to employees who actively particpate in the business. However, this salary does not need to be 100% of the total pass through for that employee. You pay the 15.3 % self - employment tax for the salary but you pay no self employment tax for the passive income.
With an LLC ALL of your income is taxed at 15.3% for being self employed.
Bottom line is the IRS does not allow you to own a business and get by without paying self employment taxes of some sort. The question is how much? An S-Corp seems to be more desireable from a taxation standpoint than an LLC. It’s a matter of informal structure (LLC) versus better tax structure (S-Corp).
An LLC can elect to be treated for tax purposes as a corporation, as a partnership, or as a disregarded entity (sole proprietor).
In the absence of a formal election, a single member LLC will default to a disregarded entity, and a multimember LLC will default to a partnership. A partnership must have at least two members.
If the LLC elects to be treated as a corporation for tax purposes, then further elects to have the corporation treated as an S-corp, it seems that all of the tax issues you have cited as drawbacks to the LLC have been overcome, while still retaining the more informal LLC operation.
If you chose to be taxed as a corporation as you suggest then you must issue stock certificates because passive income is derived directly through ownership percentage of outstanding shares of stock.
You can’t arbitrarily chose to be an S-Corp for taxation purposes without the formal structure that being such a corporation entails.
That is why LLCs are either taxed as sole proprietorships (a single member LLC must be taxed this way per the IRS unless the single member is a corporation itself and reflected on the corporate return) or as Partnerships. Either way the income is taxed without the benefit of ‘passive income’ as all income derived from a partnership is subject to Self-Employment tax.
You may be working under a false premise. The LLC and the S-Corp are two separate business entities. The LLC that elects to be treated as an S-Corp does not become an S-Corp, it is still an LLC.
The LLC can be treated as a corporation for tax purposes without actually being a formal corporation – after all LLC stands for Limited Liability Company. If treated as a corporation for tax purposes, the default is C-corp. The LLC must file a form with the IRS that converts the C-corp status to S-corp, for tax purposes only. The structure of the LLC remains intact, only the tax treatment of the LLC is affected.
Active income earned by the S-corporation (and the LLC treated as an S-Corp) does not become passive income when passed through to the shareholder(s). Active income is passed through to the taxpayer as either salary or as a dividend. Dividends are not subject to Self-employment taxes, but it does not become passive income just because it is a dividend.
If the S-Corp (and the LLC treated as an S-Corp) pays a salary, the business entity share (7.65%) of the payroll taxes is an allowed business expense. The employee share of the payroll taxes (7.65%) is deducted from his paycheck as withholdings.
Income earned by the LLC is subject to payroll taxes (self-employment income taxes) ONLY if the income earned by the LLC is active income. If the income is passive income, such as from rental property operations, then NO self-employment income taxes apply.
The LLC is governed by the applicable state law where the LLC is established. The LLC can have one or more members. If the LLC only has one member (a single-member LLC) it is treated as a sole proprietorship for tax purposes, unless the LLC has elected to be treated as a corporation. If the LLC has elected to be treated as a disregarded entity (a sole proprietorship), then all of the net income earned by the LLC is passed through to the member as self-employment income.
My question would be then how does an LLC issue dividend income? S-Corps are governed by law to issue passive dividend income with strict adherence to number of shares owned. An S-Corp cannot, for instance, issue someone 50% of the dividends if they do not own 50% of the oustanding shares.
So my confusion is that since the LLC doesn’t have any shares how would it issue dividends? My understanding is that it CAN’T. And since it can’t, it can only issue income as active income and thus ALL of the income is subject to self-employment taxes. This is why an S-Corp is indeed better than an LLC for taxation. Rental income derived from a business that a taxpayer materially participates in is non-passive and thus does not belong on form 8582 Reg. § 1.469-2(f)(6).
My understanding is that if properties are owned by an LLC (which the taxpayer materially participates in) and it generates income that income cannot be passive income.
You have raised a good point, certainly bearing further research.
Since the LLC treated for tax purposes as an S-Corp can have employees, I extrapolated other S-corp treatments to the LLC such as taking non-salary income AS a dividend from the LLC.
It may be that I have been working under an incorrect premise all along with respect to the ability of the LLC to issue a dividend.
I still maintain that the LLC income is determined by the activity generating that income. The LLC which derives its income from rental property operations, passes that income back to the member as passive income. In the same manner, can’t the S-Corp have passive income – income derived from rental property holdings – in addition to its active income? When the K-1 is issued, doesn’t the income retain its passive or active character when it is reported on the shareholder’s 1040.
Perhaps, John Hyre will pick up this thread and clear up the issue for us all.
It would appear that the answer to your question lies in the character of the income generated by the business entity.
The LLC would be better suited for passive income activities such as rental property operation because the pass through nature preserves the taxpayers ability to use the net passive loss allowance, 1031 exchanges, and capital gains tax treatments while gaining all the liability protection afforded by the entity yet preserving the more informal operating requirements of the LLC.
In states that don’t allow a single member LLC, the taxpayer would establish a multi-member LLC as a partnership with himself as a partner and a one-man Corporation “owned” by the taxpayer as the other partner. The corporation can be the manager of the LLC, collect a management fee equal to the operating costs of the business entity.
The S-Corp is better suited for active income activities so that the self-employment taxes on active income can be minimized.
You are correct, the S-Corp does have passive income but not necessarily in the manner you describe. It’s now how the income was generated that makes it passive in an S-Corp. It’s the fact that there is excess income after your salary. Just as if your S-Corp made $100,000 after all expenses except your salary. If you paid yourself $50,000 in salary, the excess $50,000 would be passive income to you, regardless of how the income was generated.
Certainly further clarification is needed, but from all that I’ve researched, it appears that ‘passive income’ as we discuss it here is reserved for individuals (i.e. income from investments, rental properties, etc) and not for LLC’s.
Here is an example of what I mean. If you have an LLC named ABC Co. and ABC’s business is lending money. Then all the income from ABC would be in the form of interest from Notes Payable. This is by nature passively generated income however, the LLC’s earnings are taxed just as if it’s income was from performing an active service such as a Dentist or similar. If the nature of ABC’s business is buying and holding rental properties then all the income derived from that activity is taxed accordingly. Maybe I’m not being clear, but ultimately everything I’ve come accross leads me to believe that ALL income from an LLC is ‘active’ income but it ‘passes through’ (pass through and passive are not the same) to the members directly on their tax returns.
I’m likewise learning about and trying to get my arms around LLC issues, so all caveats apply re a little knowledge being a dangerous thing.
But picking up on Dave’s point above, it’s been my understanding that, as to tax issues, LLC status is irrelevant. The IRS just doesn’t recognize the LLC entity, so there are no LLC tax rules about passive income, active income, etc. As Dave pointed out, the LLC makes an election about how it is to be treated for tax purposes (i.e. as an S-Corp, or as a C-Corp, or as a Sole Proprietor, etc.). So, e.g., instead of asking whether an LLC vs. S-Corp has better treatment of passive income, I think your analysis should be whether the IRS treats an S-Corp., or a C-Corp, or a partnership, or a sole proprietorship, or an individual investor, better as to passive income tax treatment. Once you have your answer, and if an LLC is otherwise the right vehicle for your needs, you can form the LLC and advise IRS of that tax status election of S-Corp or C-Corp or, etc.
I’d appreciate your and other responses because LLC rules sometimes seem pretty counter-intuitive. Good luck.
Its the nature of the business. I’m in single and multi-member RE rental LLCs, by nature this is passive income it passes to me as passive income. S-corps are great for activie income businesses that are very profitable. For example if you own an insurance agency it produces $200k per year profit. Your salary has to be a “reasonable” about, in my area $50k may be considered a reasonable salary for a insurance agent, so you make $50k of active income as an agent along with all the employment taxes, and $150 of passive income. For business that are passive or for businesses that don’t produce a profit above a reasonable salary(s), LLCs are much easier to setup. In practice, the veil of a LLC is usually stronger than that of a S-corp b/c many people get lazy with the board meetings/notes/paperwork that are not required by an LLC. You usually see LLCs for passive income activities and subdivisions of other companies, which is exactly what they are suited for.
I am an accountant and I work for a public accounting firm that specializes in real estate. There are two main reasons why real estate are structured in LLCs ratherthan in S-CORPs.
Reason #1: Basis!
First and foremorst LLCs are like partnerships. Yes, with S-CORPS you get the pass through benefit of partnerships , but LLCs provide ALL of the advantages of a Partnership. Like with Asset appreciation!
Example:
Fred contributes 1 millions dollars to LLC , while Barney contributed 1 million dollars to A S-corp. They both are purchasing seperatae buildings at a cost of 5 million dollars. Fred and Barney both have a BASIS of 1 million dollars in their respected entities.
Both buildings appreciated to 10 million dollars in 5 years and Fred and Barney both chose to refinance. They both refinaced the buildings for 5 millions dollars.
Now Fred and Barney both have a liability of 5 million dollars on the books.
Now if Fred (who has the LLC) wants to pull some money out of the deal in the form of distribution, Fred can pull out up to 6 million dollars without reconizing any gains and PAYING ANY TAXES!! Because partnerships and LLCs allow you to include your nonrecourse debt (a debt that is secured by collateral such as property) in the calculation of your Basis. Fred had a basis of 6 million dollars (1 million initial contributions and 5 million loan).
On the other hand, Barney can only pull out up to 1 millions dollars before he has to reconized gains and pay taxes. Because he doesn’t get the luxury of including non recouse debt in the calculation of his basis.
That is major reason why LLCs are used opposed to S-Corps for realestate.
Reason #2 Creativity
With LLCs you are allowed to be really creative with the formations of the entities and how the profits are allocated. For instance, Barney (S-corp) owns 20% of the stock, which means Barney is entitled to 20% of the Profit and loss.
On the other hand Fred (LLC) has a 20% interest in the LLC, but through the partnership agreement Fred could state he could get his 20% plus a “pref” (addtional interest) or he He can get 100% of the profit until he gets he million dollars back first then after he gets his 1 million back. He will only get his 20%. There are a number of possibilities.
Many new investors who form a business entity for their real estate investing can not get non-recourse loans because their entity has no credit history, no track record, and no assets.
In this case, if the LLC gets a loan, the investor has to personally guarantee the loan
Could you restate your response for this situation where only recourse debt is involved?
Only time you can get non-recourse loan is when you try to buy a property with your LLC and try to set up a mortgage for it. From what I understand, there is a bank out there that typically deals with non recourse loans for self directed iras. I’ll let the more expereinced investors exaplain.
cheers
steve
Honestly, I haven’t thought about it on a smaller scale because my firm deals with million dollar to billion dollar real estate deals. However, thinking about what I have said, when you create an new enity, the loans are based on your or you and your investor’s credit history, track record and assets. So I still think it would work under an LLC.
On the other hand I spoke to one of my colleagues today and I gave him your scenario. He stated he would will always recommend LLCs over S-Corps when it comes to real estate. Neverthless, he beleives if you are set on the S-Corp, you can take out a loan personally and then transfer the loan into the S-corp. That will give you Basis. For instance, using my first example, Barney would take out a personal loan for 5 million (if he can get it ) and contributed that loan into the S-corp.
He also said it you where just flipping and selling the properties very quickly and is not conerned about appreciation, he could see why an accoutnant would recommend an S-Corp opposed to a LLC.