LLC vs. S-Corporation
Thomas M Fafinski
Link
to Entity Selection Table
While Limited Liability Companies (“L.L.C.”)
are in particular vogue, it is still appropriate to consider using
an S-Corporation in conjunction with an L.L.C. This strategy
allows you to acquire or manage your own real estate and maximize
the limited liability benefits with more favorable tax treatment.
This strategy has really rendered the use of a sole proprietorship
or general partnership to the inexperienced.
An S-corporation and an LLC are formed in
very similar ways. In fact, the rules governing LLC’s mirror
Chapter 302A of the Minnesota Statutes, making the governing of
LLCs virtually identical to that of S-Corporations. Each have
documents which allow for their creation (Articles of Organization
and Articles of Incorporation) as well as rules which govern the
entity operation (ByLaws). While the LLC has a governing body,
referred to as the Board of Governors, the S-Corporations have the
Board of Directors. Another similar issue of concern involves
ownership by multiple parties, i.e. multiple shareholders or
members. In either an LLC or a corporation, the parties should
enter into a Buy/Sell Agreement to govern their rights upon the
happening of certain triggers (Sales to Third Party, Death,
Disability).
While the entity forms are very similar in
Minnesota, the differences are important. For instance, an
S-Corporation cannot be owned by more than 75 shareholders, while
an LLC can have an unlimited number of members. An S-Corporation
can only have one class of stock, while an LLC is able to have a
myriad of possibilities with respect to the division of control
and profits. An S-Corp cannot be owned by a non-resident alien
whereas an LLC may be owned by any person.
Perhaps the two most significant
differences, though, involve tax treatment. When an LLC is
capitalized with an asset, that asset can be distributed to it’s
members incurring taxable consequences. For example, if two
partners decide to form an LLC and become the only members of the
LLC, then subsequently purchase 2 properties, the parties could
distribute one property to one member and the other property to
the other member without incurring any tax
consequences. This is true if the distribution occurs 10 years
after it’s acquisition.
The opposite occurs with an S-Corporation.
When the same assets that were used to capitalize a corporation
are divided between the owners, that would normally give rise to a
taxable event to each shareholder receiving a distribution. The
impact can be profound in that the shareholder is taxed as though
there were a sale from the corporation at fair market value.
In other words, years of appreciation within the respective
properties would be subject to taxation. While there are a unique
set of rules which allow a corporation, in limited circumstances,
to be treated in the same way as the LLC, the entire issue can be
avoided by using the LLC form of ownership for any asset which is
appreciating in nature.
Perhaps the most important feature of an
S-Corporation, which allows it to continue to strive, is the
ability to distinguish between wage earning income (which is
subject to withholding tax) and income which is derived as a
return on investment. Any person who is self employed, or employed
by an entity in which he or she is the owner, is subject to wage
withholding tax (as is any employee). As the employer too, this
business owner is also paying the employer’s portion of the
withholding tax by virtue of their ownership in the entity. This
amounts to a penalty of approximately 18% for all income that is
considered wage earning. S-Corporations are the only method of
ownership which allows you to make a distinction between what you
earn as an employee and what you earned as a return on your
investment. With respect to C-Corporations, the return on
investment money is subject to double taxation, which is roughly
equivalent to the wage withholding tax penalty. The wage earning
services that you are performing on behalf of your corporation are
easy to quantify. You can bypass the double taxation if you
qualify to be an owner of an S Corporation by industry standards
(i.e. reasonable wage for a liquor store owner is $30,000 by
salary survey, reasonable compensation for a manager of rental
real estate is 5% of gross revenues). You are entitled to a return
on your investment and, by making this destruction with your
income as an owner of an S Corporation, you can avoid paying
withholding tax on the non-wage earning portion.
There is, however, a method of recognizing
the beneficial attributes of an LLC and an S-Crop when it comes to
business of investing in managing real estate. By holding the
asset in an LLC, you protect your appreciation from potential
taxation. By managing the asset pursuant to a management agreement
through an S-Corp, you are able to make distinctions between
income which is a return on investment. There are guidelines that
you should consider to prevent abuse of this, strategy, and reduce
the risk of inquiry by governing authorities.
Link
to Entity Selection Table
| Thomas M. Fafinski is an
attorney with BenePartum Law Group, P.A. He has been named
a Minnesota SuperLawyer by Minneapolis/St.Paul Magazine,
Twin Cities Business Monthly and Minnesota Law &
Politics in 1999, 2000, 2001 and 2002. He has been
selected to serve on the National Business Advisory
Counsel as a Minnesota Co-Chair person. BenePartum Law
Group, P.A. is a law firm that is preoccupied with its
clients rather than itself. It focuses on business owners,
investors and entrepreneurs. BenePartum Law Group, P.A.
utilizes its legal representation opportunities as a
vehicle to enhance the wealth of the business owner,
investor or entrepreneur.
Thomas M Fafinski
BenePartum Law Group, P.A.
860 Blue Gentian Rd, Suite 295
Eagan, MN 55121
(651) 994-4300
Email: tfafinski@benepartum.com
Website: http://www.benepartum.com |
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