Over the past year a number of people who have started a business or contemplated starting a business, have asked me various questions about LLCs, S-Corporations, and Partnerships and which of these forms of ownership is best.
These questions have come to me by way of visits to our office, through this blog, facebook (facebook.com/solidtaxsolutions), or even through twitter (twitter.com/@SolidTax1040). But there was a common denominator among these questions. A lack of understanding of what these entities represent and the responsibilities required by each.
So, I’ve decided to put pen to paper (so to speak) to give a foundation on which business formation and operation decisions can be made.
I’ve decided to break this up into two parts so as not to overwhelm. But keep in mind that the two parts do not represent all that needs to be considered when forming a business or contemplating changing the ‘entity type’ for the business.
So, here we go…………
While it’s too early to predict what effect any tax legislation in 2017 will have on S corporations and partnerships, you should be aware that significant changes are possible.
LLCs, S corporations, and partnerships, have been around for some time and are very popular with small businesses. But despite their extensive use, there are still a number of misconceptions among business owners and the entities have their own particular traps. This blog post is not a detailed treatise, and certainly won’t make you an expert. That would take way to many pages. Rather, I’ve tried to assemble a list of misconceptions and traps that I’ve encountered over the years. Many of the basic rules are the same for LLCs, S corporations, partnerships . I’ll point out important differences as I discuss the topic.
- The Middletown company used in the examples below is always assumed to be an S corporation or a partnership or LLC.
- References to owners can mean either shareholders or partners.
- LLCs are generally treated as partnerships (Note: An LLC can also have only one member in which there would be a different tax treatment. But for now I will talk about the LLC as if there is more that one ‘owner’, hence partnership treatment).
Basic Operation of a Pass-Through Entity
S corporations, LLCs and partnerships are known as pass-through entities. The idea behind a pass-through entity is that the entity doesn’t pay any taxes. Instead, the income and losses and certain separately stated items are passed through to the shareholders or partners and reported on their personal tax returns. That’s the big advantage of a pass-through. If a business operates as a C (regular) corporation, it pays a corporate level tax. Any payments made to the shareholders are taxed again on the shareholder’s personal tax return (therefore a double tax for C corporation shareholders. But I digress). Avoiding the corporate tax can produce substantial savings, depending on the tax level of the corporation. An additional advantage is that accidental constructive dividends (e.g., when the corporation pays for a shareholder’s personal expenses) avoid the double tax. Instead, in the case of a pass-through entity, the deduction is simply disallowed and considered a distribution.
In the simplest situation, the income or losses are passed through to the shareholders/partners. For example, Middletown, LLC has two equal partners, Darren and Fred. For the year it (the partnership) has gross receipts of $250,000 and expenses of $140,000. Of the total net income of $110,000, $55,000 is reported on Darren’s K-1 and the same amount reported on Fred’s K-1. Darren and Fred report the income on their respective Form 1040s.
Separately Stated Items
But, it’s often more complicated. Some items are considered to be “separately stated”. Instead of affecting the income or expense of the entity, they’re passed through to the owners separately. For example, Middletown, LLC makes a charitable contribution of $200. Instead of deducting that amount from Middletown, LLC’s income, it’s reported separately on the K-1 to the owners. The owners can take their share of the contribution on Schedule A of their 1040, but only if they itemize. Similarly, interest and dividend income isn’t included in the entity’s gross income, but passed through to the owners and reported on their Form 1040.
Unfortunately, a number of items that you might consider to be business income and expenses are also passed through to the shareholder/partners separately. They include the -Section 179- expense option (writing off equipment purchases), capital gains and losses, gains and losses on the sale of equipment, all credits including the work opportunity, disabled access, energy, foreign taxes, certain special expenses such reforestation expense deduction. Investment expenses, such as portfolio management fees, must also be separately stated.
Rental activities must also be passed through separately. For example, Middletown, LLC’s business is providing advice to manufacturers. Because the partners saw an opportunity to buy a building containing five small offices at an attractive price, they did so. The income and expenses of the rental property are reported on a specific tax form and the net income (or loss) is not reported on Middletown LLC’s return but passed through to the owners.
Tax Tip 1–Problems can arise if the entity has more than one owner and the owners have different tax situations. For example, Middletown, LLC bought raw land as an investment three years ago. Sue and Fred each own 50% of Middletown, LLC. Fred has a large capital gain this year; Sue rarely has investment activity. The land has declined significantly in value and Fred wants to sell it. His share of the loss could be used to offset his gain. Sue can only take $3,000 of the loss this year and carry the remainder forward indefinitely. Passive losses resulting from rentals might be limited by the phase-out of the $25,000 exception for one or more owners, but not for other owners, depending on their individual tax situation. There are other examples.
Tax Tip 2–Using the S corporation or partnership to hold investments, make contributions, etc. can increase the complexity of a return. That will add to preparation cost and make tracking certain items more difficult. While often a minor concern, before complicating your business, make sure there’s a valid reason for doing so. That may be particularly true with respect to rental properties in the business. It is often smarter to hold them in your own name or a separate LLC for both tax and non-tax reasons.
Salaries, Distributions, and Business Income
This, unfortunately, could be one of the most misunderstood areas of pass-through entities. More than once I’ve heard a taxpayer say “How could I owe so much money? I didn’t take a salary last year.” Or “I won’t take a salary so I’ll save on taxes”. Here’s were the rules on S corporations and partnerships and LLCs separate.
Basically, whether or not you take anything out of your pass-through entity, the owners will be taxed on all the income. In the case of a partnership or LLC, all the income is taxable as self-employment income. That means you’ll owe the self-employment tax on your share of the income.
An S corporation is just a ‘wee bit’ more complicated. Let us first assume that you take no salary from the corporation. In that case, like a partnership or LLC, all the income of the corporation is still taxable to the owners, but is not subject to the self-employment tax. Before you think you’ve spotted a loophole, you should be aware that the IRS requires corporate officers/employee/shareholders to take a salary. The salary you take will be subject to the usual FICA and Medicare taxes (as well as state and federal unemployment). Your share of the FICA/Medicare is withheld from your salary; the business pays the other half, just as if you were an employee at an unrelated employer.
A couple of examples should make it clearer.
Example 1–Fred is the sole shareholder of Middletown, Inc., an S corporation. Middletown, Inc. needs the cash, so Fred decides not to take a salary during 2016. He takes no distributions from the corporation of any kind. At the end of the year, Middletown, Inc. has a profit of $250,000. On his Form 1040, Fred reports the entire $250,000 of corporate profit as income. Fred has no other items of income, so his adjusted gross income is $250,000. (I assumed no other income to make the examples easier.) Example 2–Sue is the sole shareholder of Chester Inc., an S corporation. Chester, Inc. has excess cash. Sue takes her regular salary $100,000 and a distribution of $60,000. At the end of the year, Chester, Inc. has a profit of $150,000 (after accounting for Sue’s salary). On her Form 1040, Sue reports the corporation’s profit of $150,000 as income and the $100,000 salary as income. The distribution of $60,000 doesn’t enter into the computation. She has no other items of income, so her adjusted gross income is $250,000 ($100,000 in salary plus the $150,000 of Chatham’s profit).
Clearly, either way, the total income from the entities reported by the shareholders are the same. It doesn’t matter how you take the money out, or even if you take it out. The only difference will show up in FICA and Medicare taxes. By taking less of a salary, you can avoid some of these taxes. The flip side is that you’ll have less earned income for funding a pension plan or for other purposes.
There is a situation where you can end up disadvantaged from a tax standpoint.
Example 3–Middletown, Inc. has net income of $20,000 through late December. Fred, a 100% shareholder takes a $50,000 salary that creates a net loss of $30,000 for Middletown, Inc. Fred’s basis (I’ll discuss that later; for now assume it’s his investment in the corporation) is $5,000. Fred can only deduct losses up to his basis. On his personal return he’ll report $50,000 of salary, but can only deduct $5,000 of his loss.
With a partnership or LLC, the results are similar. Leave the money in or take it all out. You’re still taxed on the full amount earned. In addition, you’ll pay the self-employment tax on the full amount either way.
There may be reasons for not taking the money out, such as loan covenants, avoiding contributing funds back to the business for cash flow purposes, etc., but there are no real tax advantages or disadvantages.
Hobby Loss Rules
Just because you incorporated or set up an LLC or partnership doesn’t mean you’re immune from the hobby loss rules. The rules prevent taxpayers from deducting losses from activities that are not real businesses. This is rarely an issue if you’ve got an operating business with employees, a storefront, you have one or more years of income despite losses, etc. But if you run the business as a sideline, there are significant recreational elements (e.g., horse boarding, dog breeding), you have consistent losses that are unlikely to be reversed and you don’t carry on the activity in a business like manner (e.g., don’t keep good records, don’t attempt to reverse losses, don’t have professional advisers) you could be in trouble.
If you fall into the latter category (e.g., it’s a sideline) there are a number of steps you can take to insure you won’t have a problem with the IRS.
Tax law requires S corporations, partnerships and LLCs (and sole proprietorships) to break down their businesses into separate activities for purposes of the passive activity rules. (See next.) This could mean that if your S corporation, etc. has more than one activity, you may not be able to use losses from one to offset profits from another. For example, Middletown, Inc. has two businesses. Fred manages and operates a machine shop that rebuilds aircraft engines in Albany, NY. Sue runs Middletown Inc.’s two stores selling kayaks on Cape Cod. Neither Fred nor Sue interfere in the operation of each other’s respective activities. They get together a few hours monthly to review the combined financial statements and provide each other with business advice. Middletown Inc. must account for the businesses separately and losses from the kayak sales can’t be used to offset profits from engine rebuilding.
While this may be an extreme example, the message here is that you should not assume that you can put two completely diverse businesses together so that the losses may be utilized. When do you have to split the business into separate activities? That’s a difficult question that depends on the facts. The IRS will look at five factors–similarities or differences in the types of businesses; extent of common control; extent of common ownership; geographical location; and interdependence between the activities. There’s a good chance you won’t run into the situation. And, fortunately, even if you do, the answer is often obvious. In the example above, there’s no chance this is a single activity. But the operation of a chain of auto repair shops would be a single activity, as would rebuilding aircraft engines and operating an airport.
Passive Activities and Material Participation
One of the reasons for the complexity of the rules surrounding S corporations and partnerships stems from the ability to pass through losses to the owners. The uncontrolled use of partnerships (and S corporations to a lesser extent) in the early 1980’s led to restrictions on the use of the losses. Congress wanted to deny losses to passive investors while allowing them to owners who were active in the business. They arrived at the concept of “material participation”. If the owner materially participated in the business (as most small business owners do), the losses could be used to offset other income such as dividends, interest, salaries, etc. On the other hand, owners who did not materially participate (passive investors) could not use these losses to offset other income. They could be used to offset other passive income or used to offset other income when the investment was completed disposed of.
What’s material participation? There are seven tests. Pass any one and you’re in. Most business owners will pass one of these three tests:
- You participate in the activity for more than 500 hours during the tax year.
- Your participation constitutes substantially all of the participation in the activity of all individuals (including non owners) for the tax year.
- You significantly participate in the activity and your total participation in all significant participation activities during the year exceeds 500 hours. The threshold for significant participation is 100 hours.
Most small business owners will pass the first test. But participation counts only if it’s actually managing or working in the business. The second test is available for sidelines or very small businesses. So for example, let’s say that you’re a flight instructor and on trips to various airports you try and sell a line of aviation electronics. You’re the only employee and spend about 300 hours a year at the business. Test 3 is for owners who own a number of businesses and significantly participate in each of them for more than 100 hours a year, but don’t make the 500 hour test for any one business.
Keep in mind that there are four other tests. I’ve found that most small business owners qualify under the three listed above.
If you don’t materially participate in the activity, you can’t currently deduct the losses. The losses are passive and can only be used to offset current or future passive income or on the disposition of the activity. And that’s the reason for the definition of activity. In our example above, Sue can deduct her losses in the kayak activity. Fred can’t. He can only deduct losses incurred in his aircraft engine operation.
What does it all mean? Before you agree to part with a bunch of cash and join your buddies in a new venture, you should thoroughly understand the rules. While it still may be a good deal even if you can’t take any losses currently, you may want to reconsider.
Don’t get hung out to dry with your business, contact Solid Tax Solutions
(SolidTaxSolutions.com). It will be worth it.
We can be reached at: (845) 344-1040.
Are you ready for Part 2? Well you can read it right here.
Bruce – Your Host at The Tax Nook
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