THE TAX DIFFERENCES BETWEEN PARTNERSHIPS (LLCs), S CORPORATIONS AND C CORPORATIONS (AS OF 11/30/17)
BY ANDREA CARR, CPA
We help a lot of clients who are the beginning process of starting their company and the first large decision to make is deciding the type of entity you want to be. It’s a little confusing since companies are created under state laws and each state may have different choices and different laws regarding each type of entity. Based on the entity you created under state laws, you then need to pick how to be classified for federal tax purposes (but your choices are limited by the entity choice you made under state law). The most common classifications for federal tax purposes for entities are sole proprietorship, partnership, S Corporation, and C Corporation. You’ll likely need consult your local CPA or business attorney to figure out the types of entities you might create at the state level and the choices you have for federal tax classification purposes. For example, if you create a corporation at the Department of Commerce and Consumer Affairs (DCCA) with the State of Hawaii, you would have the choice to be taxed as an S Corporation or a C Corporation, however you could not elect to be taxed as a partnership or a Sole Proprietorship. An LLC on the other hand could elect to be classified as any of the four previously mentioned classifications assuming the LLC met certain requirements.
Often times clients work with an attorney and CPA to figure out the type of entity which works best from both a legal standpoint and a tax standpoint.
This is not meant to be an exhaustive guide and only pays close attention to the federal tax aspects (it does not address Hawaii income tax or multi-state taxation problems). Every entity is going to have different legal factors to which I won’t comment on.
Very few C Corporations in recent years are started in Hawaii. Most of Hawaii’s new businesses tend to be service businesses (doctors, veterinarians, dentists, lawyers, engineers, and accountants) and the C Corporation is unlikely to be a good choice for these types of businesses. The scarlet letter of C Corporations is they are subject to double taxation. This means if your company earns $100,000, then you’re possibly taxed at a rate 35% in the corporation (a lower tiered rate for non-service businesses), meaning the C Corporation would pay $35,000 in taxes. That leaves $65,000 in cash ($100,000 - $35,000 = $65,000) in the company which can be distributed out to the shareholders. If you were the single shareholder of your C Corporation, then you could take out $65,000 and be subject to tax in your personal tax return. On your personal tax return you might pay as high as a 23.8% (20% capital gains tax + 3.8% net investment income tax) tax on your qualified dividends, which could mean $15,470 ($65,000*23.8%) of tax individually. The result is $100,000 of income in the C Corporation could cost you $50,470. And that’s double taxation. However, those are some of the maximum rates and so the rates might be less depending on other factors.
C Corporations have a special provision where you can exclude a large amount of the gain if you ever sold the corporation. But to claim this special tax provision you must always and forever been a C Corporation. C Corporations are often the go-to choice for start-up tech companies. They’re also the entity choice you want if you ever intending on doing an initial public offering (IPO) and going public.
LLCs taxed as Partnerships
LLCs, with more than one owner, as a default are taxed as partnerships but you can elect to have your LLC taxed as a C Corporation or an S Corporation. If it’s a one owner/member LLC, then the default is it is taxed as a sole proprietorship.
Sole proprietorships are the simplest classification for federal tax purposes because a separate tax return does not need to be filed for the business. Instead all income and expenses are reported right on owner’s individual Form 1040.
A partnership files a separate tax return, called a Form 1065 which reports all the income and expenses of the business and then shows how much of the profits should be allocated to each partner. The allocation of profits for tax purposes is generally defined in the partnership operating agreement (a legal document).
So for example, if the partnership made $100,000 and each partner should be allocated 50% of the profits, then each partner receives a Form K-1 which shows $50,000 to be reported on their individual tax returns. It generally does not matter whether either of the partners took the $50,000 out of the business bank account and moved it to their own. One partner might take $50,000 out of the business bank account and the other might leave their $50,000 in, but both will still be taxed on $50,000 each. Many partners in partnerships are confused when they have to pay tax on $50,000 of income when they didn’t receive any money. If this is the case, the partner should attempt to reconcile the taxable income reported to them on the Form K-1 and the amount of money available for them in the business banking account and determine what, if any, is the discrepancy. This could be a symptom of a deeper problem with the partnership’s bookkeeping.
Partners who are actively engaged in running the business, will likely be subject to additional tax called self-employment tax. Self-employment tax is separate from income taxes. The self-employment tax is also generally assessed on the net income from a sole proprietorship.
If you review a paystub, you’ll see that 6.2% is deducted for social security taxes and 1.45% is deducted for Medicare taxes. What isn't shown is that an employer is also paying 6.2% and 1.45% on those same wages on behalf of the employee. About 15% of earnings for most individuals are supposed to go towards social security and Medicare. When you’re an employee these are referred to as payroll taxes, when you’re self-employed you are treated as employee and employer which makes you subject to pay the whole 15% (referred to as self-employment taxes). Going forward I might refer to payroll taxes and self-employment tax separately, but it should be noted these are the same taxes and should be treated as similar when comparing tax projections.
Self-employment tax on partners is generally assessed on each partner’s allocable share of income from the partnership. Back to this example of a partnership earning $100,000, and each partner being allocated $50,000. Each partner would pay approximately $7,000 of self-employment tax on their share of $50,000 if both were actively engaged in the business. There would also be the income tax which could range from 0% to 39.6%. So there’s a chance both partners could pay as high as $27,000 each of taxes ($54,000 in total on the $100,000 of income), except to reach the 39.6% rate you would need to make over $415,000 as a single person.
S Corporations work very similar to partnerships, but they have more restrictions, are less flexible, and have to do payroll. Partnerships do not do payroll for the partners, meaning the partners won’t receive paychecks with an accompanying paystub. S Corporation owners who are involved in the business will receive a paycheck and paystub.
Doing payroll is a very time-consuming process and has many pitfalls for penalties if done incorrectly. We advise clients to avoid doing payroll if possible since starting payroll is very time-consuming and costly. Payroll involves making federal tax deposits where the frequency depends on the amount being deposited, but you could be making deposits as often as semi-weekly. It involves quarterly tax forms to the IRS and also involve state tax forms which could happen as frequently as monthly. It could also involve getting temporary disability insurance (TDI), worker’s compensation, Hawaii unemployment insurance, and health insurance for all employees. Often the first employee is the hardest because it involves the initial set up with various agencies and insurance companies and getting used the frequency of filing a lot of forms.
There are payroll services which handle the compliance aspect but those payroll services tend to be very costly. The upside is we’ve seen tech companies slowly move into the payroll services arena which are driving prices down.
Payroll must be done for any corporation (S or C) where someone performs work for the corporation including managerial services. This means for almost all owners of S Corporations or C Corporations, the owners should be on payroll.
But an S Corporation works as follows: If the company earned $100,000 before any salaries, and the determined reasonable compensation to each owner is $40,000, then the net income from the S Corporation would be $100,000 less $40,000 for shareholder 1, less $40,000 for shareholder 2, which would equal $20,000. On each of the $40,000 to each shareholder, payroll taxes would need to be paid which would be about $6,000 each.
Both owners would then include $10,000 each (assuming 50% ownership each - $20,000 * 50% = $10,000) as their distributable share of S Corporation income (“distributable income”), but also remember they would include $40,000 of the wages from the corporation in their personal taxes as well. The result is that just like a partnership, each owner is taxed on $50,000 of income at their ordinary income tax rates.
The question then is what is the difference between an S Corporation and a partnership? The answer is doing payroll and payroll taxes. Each owner in the S Corporation in the example above pays $6,000 in payroll taxes. In the example, regarding a partnership, each partner pays $7,000 of self-employment tax (which is the payroll tax equivalent). One might conclude an S Corporation is far superior to a partnership because each owner pays $1,000 less in payroll/self-employment tax, but I would say the S Corporation with these facts is a bad choice. So under this scenario where the company earns $100,000, the owners might save $1,000 each (or $2,000 together in payroll taxes), here are the reasons this would be ill advised.
1. If this was a service firm, for example a bookkeeping firm, the IRS might argue the $40,000 paid to each owner is unreasonable compensation, and that reasonable compensation is $50,000 each (since it’s a service firm and all money is earned because of services provided). If the IRS won their argument then there would be no payroll tax savings because all $50,000 is being subject to payroll taxes. One of the largest audit risks in the past decade has been S Corporations with little to no payroll to owners.
2. Payroll is very time-consuming and there are additional payroll costs such as TDI, workers compensation, and Hawaii unemployment insurance. A new company in Hawaii in 2017 faces a rate of 2.4% for unemployment insurance on each employee’s wages which are less than $44,000. Meaning this company would pay $1,920 ($40,000 * 2.4%) in their first year for unemployment insurance that the owners can’t even collect on. That alone eats away at the $2,000 savings that came from being an S Corporation.
When is an S Corporation a good idea?
The quick and easy answer is when you plan to make lots and lots of money. The tax savings between an S Corporation and a partnership is generally just the payroll taxes. But payroll taxes are generally regressive, along with the costs of doing payroll. There’s economies of scale in the costs of doing payroll. As the numbers become much larger, the savings in the payroll taxes/self-employment taxes start to matter…..a lot.
Changing the example, let’s pretend the company made $1,000,000 of income before paying out wages to the owners. Our general belief is to satisfy the reasonable compensation requirement, wages to each owner should be at least $127,200, which is the maximum amount of wages subject to the social security tax. As mentioned before the payroll/self-employment tax is made up of two separate taxes, the social security portion 12.4% (6.2% times 2) and the Medicare portion 2.9% (1.45% times 2). The Medicare portion, 2.9% applies to all wages. The 12.4% only applies to only wages up to $127,200 for 2017 (this amount is indexed for inflation).
The savings then becomes the Medicare tax of 2.9%. However, there is an additional Medicare tax enacted under the Affordable Care Act which assessed a 0.9% on all wages exceeding $200,000 for a single person. But for simplicity I won’t include that in our calculation.
Back to the example, for a company which earned $1,000,000 before paying the owners, the reasonable compensation could be set at $130,000 for each owner. For $130,000 of wages, we’ll assume around $19,500 of payroll/self-employment tax.
$1,000,000 less $130,000 for owner 1, and less $130,000 for owner 2 = $740,000 of distributable income for the S Corporation. Each owner would add $370,000 of distributable share of income plus their $130,000 of wages from the S Corporation, resulting in $500,000 of income from the S Corporation.
If this same example was instead a partnership, each partner would be taxed on $500,000 of distributable income from the partnership, which would result in about $30,000 each of payroll taxes.
The income taxes (not payroll/self-employment taxes) should be the same whether the entity was taxed as an S Corporation or a partnership.
The result is each partner saves around $10,500 of payroll taxes ($30,000 - $19,500) which starts to make doing payroll more palatable. The total savings together would be $21,000. And one of my previous reasons for not doing payroll was Hawaii unemployment insurance. However, unemployment insurance is just 2.4% on the first $44,000 of wages, meaning on $130,000 each of wages, the company just pays $2,112 of unemployment insurance ($44,000*2.4%).
The conclusion is as the numbers grow larger an S Corporation starts to result in larger tax savings. Often your best bet is forming an LLC taxed as a partnership in the beginning and as the company grows to make the S Election (electing your LLC to be taxed as S Corporation) later on once you hit that breakeven point where it’s more sensible to be an S Corporation. Also, it might make sense to change from a partnership to an S Corporation once you start hiring other employees (non-owners). If you’re already have other employees (non-owners) on payroll, adding the owners onto payroll isn’t very hard.
Should my LLC partnership interest be owned by my individual S Corporation?
Some people have been telling me how they formed an LLC taxed as a partnership with their business partner but want to each own their separate partnership interest in their individual S Corporations. From the scenarios I’ve seen, I can’t see any benefit to having three separate entities, when you could as easily just have one S Corporation. If you were committed to having the S Corporation structure, it’s far cheaper to have one S Corporation, than one partnership and two S Corporations. And here are my reasons:
- I don’t see any tax savings in this structure, vs. one S Corporation with two owners
- For retirement plans all three companies will be subject to the controlled and affiliated groups meaning they will all be treated as one company for determining the retirement plan limits
- You create tax filings for three companies instead of one company
- You’re doing payroll for two or three companies instead of one company
- You might need a business valuation of the partnership interest if you ever wanted to move the partnership interest out of the individual S Corporation