WHY ARE YOU USING AN LLC?
Beware of this delicious and highly intoxicating punch: it packs quite a punch! After just one glass you will begin to think that using an LLC for your business is just fine. After two glasses you will recommend LLC’s to all your friends and neighbors. And after three glasses the whole thing will become a police matter and you will be out of luck.
OK. You insist on the recipe so here it is (remember I warned you!):
UPDATE: JANUARY, 2014
When this article was initially written the social security tax rate was 13.3%. Starting in 2013 this rate increased to 15.3%. The effect of this significant increase in social security taxes makes the arguments and conclusions of this article even more compelling. It has become even more important to ask this question: Why are you over-paying social security taxes?
The center of attention remains the same: Look at Line 56, Page Two of your Form 1040 and ask your accountant to explain this number to you.
WHAT IS AN LLC?
LLC stands for Limited Liability Company and is a form of business organization that came into existence in the 1990’s. For tax purposes most LLC’s are treated like a partnership, which means LLC net income is taxed to its owners proportionately. (In rare cases LLC’s elect to be taxed as C or S corporations.) So if an LLC has a profit of $100 and you own 10% then $10 of the profit will be taxed to you on your individual tax return, unless you specify a different way of allocating profit or loss.
Unlike S corporations, LLC’s offer flexibility in determining how profits and losses are allocated among owners. But this flexibility comes at a steep price: most types of profit earned by an LLC are hit with the 13.3% social security tax in addition to income taxes. This social security tax is the primary reason why LLC’s are a very poor choice for most types of businesses. Under current law the social security tax rate is scheduled to rise to 15.3% on January 1, 2013.
Because the net income or loss of an LLC flows through to the owners, LLC’s don’t pay taxes themselves and for this reason they are classified as ‘pass-through’ entities.
WHY IS IT A MISTAKE TO USE AN LLC?
Pursuant to Internal Revenue Code Section 1402 and IRS Regulation Section 1.1402(a)(2) and 1.1402(b) most types of profit earned by an LLC are exposed to the 13.3% social security tax. This tax is IN ADDITION TO federal and state income taxes. Under current law, social security taxes are scheduled to return to the previous rate of 15.3% on the first $110,100 (yet to be indexed for inflation) of income starting on January 1, 2013. And income above this limit is still hit with an unlimited 2.9% Medicare tax. The misery never ends with an LLC.
Pursuant to IRS Regulation Section 1.1402(a)-1(b) guaranteed payments paid to an owner by the LLC for BOTH services and use of capital are fully subject to the social security tax.
Thus, if your federal income tax rate is 20%, and your Maine income tax rate is 5%, as an LLC owner you will also be hit with an additional 13.3% social security tax. In this case your total (nominal) tax burden would be 38.3%! This is unnecessary.
If a business is operated as an S corporation instead of as an LLC then social security taxes can be controlled and limited. Owners of S corporations must still pay some social security taxes on “reasonable compensation” (defined in IRS Revenue Ruling 74-44 and related court cases). But the difference between income before paying compensation and owner’s salary escapes the social security taxes with an S corporation, but not with an LLC.
For more details on S corporation reasonable compensation see Note B(7) in the Appendix.
A SIMPLIFIED EXAMPLE: LLC VERSUS S CORPORATION
Consider this simplified illustrative example using 2011 tax rates. Assume business income before paying salary to the owner is $120,000. (LLC’s don’t pay salary to owners, only S corps do. See Note D in the Appendix.) Further assume that “reasonable compensation” for the owner of this business is $45,000. Here are the results:
Savings From S Corporation
|Total Taxes $||45,916||39,083||6,833|
The S corporation produces $6,833 of tax savings in a single year. See the Appendix, Note E for a comprehensive analysis of this example where all relevant facts are considered systematically.
REALITY CHECK: LOOK AT LINE 57 (Line 56 for Years Prior to 2014)
If you think you’re doing great with tax planning and how your business is organized do a quick reality check. Look at the second page of your Form 1040, Line 57 (Line 56 for years before 2014). This line reports the self-employment taxes you were charged on LLC (or Schedule C or partnership) net income. If you see a four or (wow!) five digit number there then the fire alarm has just gone off for you. Call your accountant immediately and ask why this is happening. Make the call now and insist on an answer you understand.
Don’t fly the flag of folly. Do a quick reality check on your taxes. Face the truth, don’t fear it.
Unfortunately many accountants are just not knowledgeable of this issue. One of the funniest things I see from time to time is some version of the following business name:
Joe Don’t-Know CPA LLC
Poor Joe. But I pity his clients even more.
To liberate yourself from unnecessary taxes you must achieve better thinking. See here:
WHY WOULD ANYONE USE AN LLC?
There are four special cases where it is not only acceptable to use an LLC, but actually preferred because of the greater flexibility of the LLC entity. LLC’s can allocate gains and losses with far greater flexibility than an S corporation. But this flexibility may be meaningless for most small family businesses. LLC’s also have more favorable rules on deducting business losses because owners may receive basis credit for personally guaranteeing the loans of the business, unlike S corporations. But these rules are complex.
Congress has enacted these four exceptions to the rule that LLC (partnership) income is subject to the 13.3% social security tax. Here are the exceptions:
(1) Rental (landlord) income for non-dealers (See Appendix Note C about who is a “dealer”) per IRC Section 1402(a)(1);
(2) Dividend and interest income of investors (again, not dealers) per IRC Section 1402(a)(2);
(3) Capital gain income per IRC Section 1402(a)(3);
(4) Passive limited partners of the LLC may qualify for exemption from the social security tax pursuant to IRC Section 1402(a)(13) and IRS proposed Regulation 1.1402(a)-2.
If you answered “no” to each of these then you should say “no” to being an LLC.
If you are not a “dealer” and are a landlord or investor, an LLC may be the best entity to use for your business. If you are a passive investor an LLC may be OK for you, but your fellow (active) owners won’t be happy at all with the additional social security taxes they will pay on their share of business income. At least one person must always be an “active” manager or member of the LLC and this person gets burned with the social security tax on their share of LLC income.
WHAT'S SO BAD ABOUT PAYING EXTRA SOCIAL SECURITY TAXES?
If you pay less social security taxes then, yes, your future benefits will theoretically be less. Are you a big believer in social security? Do you trust the government with your money? If you have an extra dollar to invest where should you invest it: in the social security system or in a retirement plan you own and control such as a Roth IRA?
Maybe a future wise and effective government will rescue social security and keep it going. Maybe not.
You have one and only one opportunity to prepare for your retirement. Choose wisely. Think twice before ordering another glass of LLC punch. If you’re in your 40’s or older you can be sure it’s the last call for drinks: Bar Closing Down.
There is One Group of People Who SHOULD Pay Extra Social Security Taxes
The blunt truth is that there is one group of people who should pay extra social security taxes: People Who Don’t Trust Themselves. This group includes compulsive gamblers, spendthrifts, shopaholics, and those who simply don’t want the headaches and responsibility of handling their own retirement and who prefer, instead, to trust the government with their money. When it comes to tax planning there is no such thing as one size fits all.
If these people save money on their taxes they will simply spend the savings recklessly and end up with nothing in the long-run. These individuals know this. The logic which applies to these people is that something, anything, is better than nothing. They are indeed better off giving extra money to the government because there is, at least, a snowball’s chance in hell they might get something for their money. But you can be sure that whatever you do get from the government will be LESS than what you might have gotten if you had invested your money wisely.
If you belong to this group of individuals be honest with yourself and your accountant so the best possible decisions can be made. One of the most important qualities about managing your money and taxes is having a comfort level and believing in what you are doing based on your own facts and circumstances. Abstract, theoretical solutions devised by mathematicians may look good on paper, but may turn out to be lousy in the day-to-day practical life of real people.
Managing money and taxes correctly requires that ALL facts be carefully considered, including you, your preferences, your lifestyle and your habits. It is folly to offer ideal solutions to managing taxes and money that makes sense only if a person is perfect. The truth is that few if anyone in this world is perfect and we must all accept and live with this reality.
In my experience a small minority of people belong in the group who should pay extra social security taxes. The vast majority of people will be far better off saving on this tax and investing their savings wisely. But if you don’t trust yourself to do this then accept this fact honestly and resign yourself to trusting the government with your money. You should completely ignore this article about LLC’s.
Accountants are specifically trained to help people save money on taxes. Their entire orientation, education, and attitude lead them to find ways to reduce taxes. Thus, it is extremely difficult and challenging for accountants to deal with the small minority of people who cannot benefit from advice which helps them save on taxes. This is unfortunate but true and is simply a fact of life.
I have heard many of my fellow accountants describe individuals who cannot benefit from their advice as foolish. When I was a young, junior accountant I would actually get angry with this type of client. But this is wrong. Individuals who cannot benefit from advice which helps them save on taxes mostly know this. They are simply making the best economic decisions they can given this fact. It is wrong and disrespectful for accountants to criticize such individuals. The old saying about horses is true as ever in this context:
You can lead a horse to water, but you can’t make him drink.
Horses have a mind of their own and make their own decisions which should be respected and understood.
There is another ancient saying which is highly relevant for my fellow accountants. It comes from the founder of the medical profession:
Above all, do no harm.
True intelligence consists of systematically and comprehensively understanding everything which is relevant, including human psychology and real-world behavior. Mathematics, and good judgment, must be applied not merely to dollars but also to people.
THE BOTTOM LINE
It’s really, really clear that in most cases an S corporation produces dramatic and recurring tax savings compared to LLC’s. See the graph in Note B of the Appendix. However, the only way to definitively prove that a given business entity is best for you is to mathematically evaluate your own unique situation. I’ve performed these analyses for many clients and provided certainty and confidence that a given choice is the best solution. I’ve done this work for twenty years.
The bottom line is that there is no substitute for good thinking and never will be.
WHAT WAS JOE DRINKING?
Notes and Comments to Specialists
(And Those Who Really Want to Know)
Note A: Detailed Comparison of S Corporations Versus LLC’s
|Formation||(1) File Articles of Organization
(2) Get Tax ID # From IRS
(3) Elect Worker's Comp if Desired
|(1) File Articles of Incorporation
(2) Get Tax ID # From IRS
(3) File IRS Form 2553
(4) Waive Worker's Comp if Desired
|Costs To Form(Maine):
|Who Can Own||Virtually anyone or another entity such as a trust, corporation, LLC, etc.||(1) U.S. Citizens Only
(2) Maximum of 100 shareholders
(3) Individuals, estates, some trusts
|Allocation of Profits & Losses||Significant Flexibility||(1) Per share per day
(2) No second class of stock but non-voting stock is allowed
|Allocation of Draws / Distributions||Significant Flexibility||(1) Per share per day
(2) Must pay "reasonable salary" to owners to balance tax-free distributions.
|Pass-Through of Profits & Losses To Owners||Yes||Yes
(But some Corporate level tax in rare cases.)
|Deduction of Losses||Member's generally receive credit for the loans of the business which facilitates easier deduction of business losses.
||Shareholders do NOT receive credit for personally guaranteeing company loans. More difficult to deduct business losses.
|Social Security Tax on Profits||Yes, except for non-dealer income from rent, interest & dividends, capital gains, and income taxed to passive members.
||No. However, the company must pay reasonable salary to owner-officers, and this salary is subject to social security taxes.
|Maine Worker's Compensation for Owners||Owners are automatically exempt from coverage, but may elect to be covered.||Owners are automatically required to have coverage but may waive it if they own 20% or more of the company.
|Maine Worker's Comp. Minimum Annual Payroll Base for Owner's Coverage
(2012 NCCI Basic Manual Rule 2-E-3)
|Basis Credit for Profits Retained by Company
|Owner Pay Subject to Maine Unemployment Taxes||No||Yes|
Note B: Graph of Total Taxes by Entity
Key Assumptions and Comments To the Graph
(1) This graph of total taxes by entity was generated using the Excel model shown in Note E of the Appendix. Income before salary is paid reflects all business income and expenses except for salary paid to the owner. For LLC's this amount is zero since LLC's do not pay owner salary.
(2) Assumes marginal federal and Maine tax rates of 20% and 8% respectively.
(3) Uses 2011 social security tax rate on first $106,800 of income of 13.3%; above this threshold the 2.9% Medicare tax continues without limitation. For 2012 the social security threshold is $110,100.
(4) Reasonable compensation salary for the sole owner-operator of the business is estimated to be 37.5% of income before deducting salary.
(5) The effect of the alternative minimum tax was disregarded for simplicity.
(6) The LLC pays more taxes than an S corporation over the entire income range. At higher income ranges a lower reasonable salary for the owner-operator may be justified if profits are generated by goodwill or capital instead of the services of the owner-operator. Thus, the graph conservatively UNDERSTATES the tax savings achievable with an S corporation.
(7) S corporation reasonable compensation is a subject worthy of its own article. Here is a summary of the key principles including IRS Revenue Ruling 74-44:
Emergence of the Multi-Factor Model for Assessing Reasonable Compensation
The net effect of court cases and rulings has been the de facto emergence of a multi-factor model to determine if S corporation compensation is reasonable or not. The failure of Congress and the IRS to remove ambiguities inherent in assessing reasonable compensation has resulted in the following 12 factor analytical model used by the Tax Courts:
(1) Qualifications of employee
(2) Nature and scope of work
(3) Size and complexity of business
(4) Ratios of salary to net income, sales, capital
(5) Economic Conditions
(6) Ratio of salary to distributions
(7) Salary policy
(8) Financial condition (company’s ability to pay)
(9) Comparable pay
(10) Prior year pay
(11) Arm's length negotiation of pay
(12) Employee guarantees of company debt
Taken from Economic Research Institute CPE course for CPA's: "IRS Reasonable Compensation." The course may be accessed online for free at:
The IRS's own guidance on this issue adopts many of these factors while clearly acknowledging that a fair return for capital and equipment (via distributions) is not compensation for services. This means the IRS position is in substantial agreement with the Exacto Spring Corp. case.
IRS Regulation Section 1.162-7(b)(3) and most courts have placed the greatest emphasis of all on comparable pay as the most important factor in determining the reasonableness of salary.
In late 2003 the IRS approached the Economic Research Institute (ERI), a pre-eminent, trusted, and credible source of national economic information with access to thousands of compensation databases, for the purpose of determining the reasonableness of owner/manager compensation.
The IRS established a 2.00 standard error criterion for the purpose of determining reasonableness. This means that about 95% of compensation would, statistically speaking, be considered reasonable. In other words, compensation at or below the 2.5th percentile and at or above the 97.5th percentile would be deemed unreasonable. This thinking reflects sound statistical principles regarding 'outliers' or very rare instances. Further, accepting as reasonable all compensation that is within 2.00 standard errors above and below the mean acknowledges the significant subjectivity, ambiguities and inconsistencies inherent in the 12 factor analytical model used by the courts. Of course taxpayers could rebut a finding of unreasonableness by substantiating extraordinary circumstances.
A demo version of ERI’s evaluation software is available at:
Note that ERI’s comparable salary amounts tend to be extremely conservative for reasons disclosed in their introductory disclaimer:
|Since ERI observations are restricted to only the publicly disclosed executive salaries rather than the sum total of all observations from all survey sources whose updated competitive figures are reflected in the database, ERI's reliability statistics are considered to be extremely conservative. [Emphasis added.]|
Note C: Who Is a “Dealer”?
Welcome to one of the most heavily litigated areas of the tax law. This is the subject where tax lawyers make big bucks. The IRS and taxpayers routinely disagree over who is a dealer. Here are the relevant rules:
Dealer status under the Internal Revenue Code is determined primarily by the intent of the taxpayer. What were you thinking, when, and why? The IRS evaluates intent by looking at the facts and circumstances of your case, including the number, frequency and continuity of sales.
If you sell stocks or real estate all the time, continuously, regularly, you are a dealer. What you sell is treated as inventory. Gains from sales will be taxed as ordinary income, not capital gains. Further, you may be subject to social security taxes. Dealers should use S corporations to minimize their tax burden.
If you sell stocks or real estate infrequently, discontinuously, and irregularly, then you are an investor, not a dealer. You buy, hold and seek long term capital appreciation. What you sell is NOT treated as inventory. Gains from sales will be taxed as capital gains and you will never be subject to social security taxes on these gains. An LLC may be the ideal entity for you.
In between these two extremes of dealer and investor is a vast gray area, a combat zone where the IRS and taxpayers battle it out. No definitive test provides clarity or guidance as to whether or not you are a dealer. Why not? This is a very good question.
See IRS Publication 544 and IRC Section 1221 for additional information.
Note D: Why Is It That LLC’s Don’t Pay Salary to Their Owners?
It has long been clear that partners of partnerships and, therefore, members of LLC’s are not employees. This lack of employee status applies to employment tax law, retirement rules, and fringe benefits. See IRS Revenue Ruling 91-26. And see this informative article for further information:
Note E: Comprehensive Comparative Analysis of LLC versus S Corporation – An Illustrative Case Study
S CORP VERSUS LLC: COMPREHENSIVE ILLUSTRATIVE EXAMPLE
A Battle to the Death
|Business Income Before Owner Salary and Related Payroll Taxes||$120,000||$120,000||$0|
|Reasonable Compensation Deduction for Salary Paid to Owner||($45,000)||N/A||($45,000)|
|Employer Social Security Tax Deduction @ 7.65% on Owner's Pay||($3,443)||N/A||($3,443)|
|Employer Federal Unemployment Tax (Maximum) on Owner's Pay||($42)||N/A||($42)|
|Employer Maine Unemployment Tax (Maximum) on Owner's Pay||($600)||N/A||($600)|
|Net Business Income Taxed to Owner||$70,916||$120,000||($49,085)|
|OWNER'S PERSONAL TAX RETURN (Assume 1 owner)||S-Corp||LLC||Difference|
|Owner Salary (Form W-2) Paid By S corporation||$45,000||N/A||$45,000|
|Business Net Income Taxed to Owner (From Above)||$70,916||$120,000||($49,085)|
|Total Income Taxed on Owner's Personal Tax Return||$115,916||$120,000||($4,085)|
|THE BOTTOM LINE: TOTAL TAXES (2011 RATES)||S-Corp||LLC||Difference|
|Federal Income Tax at 20%||$23,183||$24,000||($817)|
|Maine Income Tax at 8%||$9,273||$9,600||($327)|
|Income Tax Benefit of Deduction for 1/2 of Social Security Taxes on LLC Net Income||N/A||($2,005)||$2,005|
|Social Security Taxes||$5,985||$14,321||($8,336)|
|Unemployment Taxes on Owner Salary||$642||N/A||$642|
CONCLUSIONS AND COMMENTS:
It costs $6,833 more to operate this business as an LLC compared to using an S corporation.
LLC income up to $106,800 is hit with the full social security tax rate of 13.3%. Income above this threshold is hit with the unlimited 2.9% Medicare tax. S corps are not subject to this tax exposure.
The owner salary paid by the S corporation is subject to federal and Maine unemployment taxes. LLC profits are not subject to unemployment taxes. LLC's do not pay salaries to owners; instead LLC's may pay "guaranteed payments" to owners for services or capital. In both cases guaranteed payments are fully subject to social security taxes.
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339
©2015 Copyright George Adams CPA MBA. All Rights Reserved.