This article originally appeared in the August 2014 issue of Smart Business Philadelphia magazine.
One of the first tasks a new business owner must address involves the question — What type of entity should I choose to operate my business?
"A common tax consideration is a desire to avoid double tax in which the operating profit of a business is taxed initially at the entity level, followed by an additional tax when after-tax profit is distributed to the owners," says Michael R. Viens, Director, Tax Strategies, Kreischer Miller.
Smart Business spoke with Viens about considerations that may arise should you decide to operate a business venture as a pass-through entity, either a limited liability company (LLC) or an S corporation.
Does incorporation help protect personal assets from a business?
When a company decides to operate a business using a formal intermediary entity, it’s typically to shield the business owners’ personal assets from the risks of the business’s creditors. Both LLCs and S corporations offer this benefit. But there are formalities that must be addressed to assure such results.
Some advisers argue that the formalities and related paperwork are more of a burden for an S corporation. For example, there are annual meetings and corporate minutes requirements. An LLC avoids such requirements. Such activities need not be a material burden, however, and offsetting this issue is the greater clarity an S corporation offers with its formal ownership structure.
S corporations do have greater restrictions on ownership than LLCs. Permitted S corporation shareholders are both limited in number (no more than 100) and type (generally, U.S. citizens or permanent residents and certain trusts).
What are the tax implications between the two types of entities?
An owner in an LLC is treated as a partner in a partnership for tax purposes and partners do not qualify as common-law employees with regard to the partnership. LLC owners cannot receive W-2 wages in which tax is withheld, and thus owners are required to make quarterly estimated tax filings, a consideration that could weigh against using an LLC.
Wages paid to an S corporation owner for services performed are subject to Social Security and Medicare taxes but allocations of S corporation profits will not be.
Allocations of LLC profits to a member who performs services in the LLC generally will be subject to Social Security and Medicare taxes. For a service-oriented business venture, this can favor an S corporation. It is important to note, however, that tax reform provisions now being considered would potentially eliminate the favorable benefit currently realized by S corporation shareholders.
Where the activities of the business venture do not involve personal services but rather some form of investment activity, passive income limitations may prevent the use of an S corporation. Using an LLC for ownership of real estate involved in rental activities is usually preferred.
If a business venture will own property likely to appreciate in value and a reasonable prospect exists that new owners will acquire a future interest, an LLC provides for favorable tax considerations to such owners. They may acquire a stepped-up basis to be used to determine both deductions flowing to them as well as their share of any gain or loss upon disposition of such assets by the LLC. No such basis step-up is allowed to S corporation shareholders.
Where losses may be anticipated from business operations, an LLC may provide a better outcome to the owners since loss limitations referencing owners’ basis will typically include mortgage and other debt inside the entity. S corporation shareholders are limited to their stock basis and any personal loans they have made to the entity.
Which type is better?
It is not uncommon for there to be some level of uncertainty about which form represents the best solution when a new business venture is launched. In such circumstances, consider going with an LLC approach at least initially while reserving the option to change to an S corporation in the future. Such a change can generally be carried out with little or no immediate tax implications, while a move in the opposite direction can present significant tax costs. ●