In this episode of Toni Talks, enrolled agent (EA) Toni Covey is joined by special guests Eliot Thomas, Esq. and Troy Butler, Anderson’s Booking Manager, to give an overview of business entities, including the major tax and asset protection aspects of limited liability companies (LLCs), partnerships, C-corporations, and S-corporations.
Updated October 20, 2020
Entity structuring is a crucial piece of business planning. Selecting the right entity for your business or investing can make all the difference when it comes to your tax bill, your bottom line, and your ability to secure funding for your endeavors. So, let’s explore the major types of business entities: limited liability companies (LLCs), partnerships, C-corporations, and S-corporations.
Limited Liability Companies (LLCs)
Limited liability companies (LLCs) are the most versatile business entity because an LLC can actually “be” any other entity type.
Tax Status Options for LLCs
In my experience, the most commonly misunderstood-shape an LLC can take is the disregarded LLC. Disregarded LLCs simply do not file their own tax return. Disregarded LLCs do not file a separate tax return at all. Instead, all of the income and expenses of a disregarded LLC will land on the tax return of the individual or entity to which the LLC is disregarded.
To be clear: the income and expenses of a disregarded LLC are still reported, just not on a separate tax return. If the LLC is disregarded, its tax return will take the shape of whatever it’s disregarded to. So, if the LLC is disregarded to your personal return, you’ll report it on your Form 1040.
The owners of an LLC are called its “members.” These are basically the LLC-equivalent of the shareholders in a corporation.
When you set up an LLC, there are two layers of bureaucracy that must be addressed: the state and the federal government. You file the LLC’s articles of organization with the state, and the state then recognizes the LLC as a business entity. When you file the LLC with the IRS to get an EIN, if there’s only one member (owner), the LLC will automatically default to a disregarded LLC.
Partnerships & Corporations
If there is more than one member (owner) of an LLC, the LLC is automatically defaulted to be treated as a partnership by the federal government. The tax form for partnership returns is Form 1065. However, LLCs with more than one member can also function as C-corporations or S-corporations, each of which files its own tax returns (Forms 1120 and 1120S, respectively). If you want your LLC to be treated as a C-corporation or an S-corporation, you’ll have to make a special election with the federal government for that using Form 8832 (for C-corporation, partnership, or disregarded status if not already a disregarded LLC) or Form 2553 (for S-corporation status).
LLCs & Asset Protection
As the name implies, limited liability companies (LLCs) limit the liability of the owners. The liability of an LLC’s owner(s) is limited to whatever amount the owner(s) put into the LLC.
Furthermore, LLCs in certain jurisdictions offer charging order protection, which is another lawsuit deterrent. The benefit of charging order protections for an LLC is that any judgment or creditor has no choice but to wait for you (or the LLC’s manager) to authorize a distribution to the creditor for the judgment to be satisfied. Even then, it is the creditor who is responsible for the tax liability for any income generated in that period. This makes LLCs less likely to become tangled up in lawsuits.
One of the biggest differences between LLCs and limited partnerships (LPs) right off the bat is that LLCs can have only one member, whereas partnerships must have at least two. An LP must have a general partner, who takes on all the liability, and any income earned in that role will typically be active income. LPs must also have a limited partner, who has limited liability up to the amount they put into the LP, and any income earned in that role is passive.
One of the appealing aspects of using an LP instead of an LLC is that LPs are older and more established as business entities. Limited liability companies are newer. There is a lot of existing case law surrounding LPs, which makes them a more comfortable choice for some.
Partnerships file tax returns via Form 1065; the income will then flow through to each partner via Form K-1. A K-1 is kind of like a W-2 if you will.
C-corporations are popular because they are actually separate taxpayers. The C-corporation’s income, unlike the income of an LLC or LP (unless the LLC has elected C-corporation tax status), does not flow through to its individual owners.
One of the major concerns many people have about C-corporations is the potential for double taxation. Due to the Tax Cuts and Jobs Act, C-corporations are taxed at a flat 21% rate. It’s hard to get money out of a C-corporation because it has its own tax return and tax rate, and the money has to stay in the corporation since it’s a separate and distinct entity.
One way to get money out of a C-corporation is to run payroll. The problem with payroll is that you have to pay payroll tax. You could also choose to take a dividend from the corporation as a shareholder, but you would then own taxes on the dividend. Dividend distributions are not tax-deductible to the corporation, so the corporation will pay taxes, then you as an individual will pay taxes at your individual long-term capital gains tax bracket.
One of the tools we use here at Anderson to combat this is loans from shareholder accounts. If you pay for your own healthcare premiums or Section 280A meetings, you can essentially reimburse yourself from the corporation tax-free. You can set up an accountable plan and reimburse yourself as an officer of the corporation for out-of-pocket expenses.
If you personally pay for something for the benefit of the corporation and it’s for a reasonable business expense, then the corporation can reimburse you through an accountable plan. As a reimbursement, this money is not taxable to you. Plus, it’s a deduction to the corporation. The accountable plan is your way of telling the IRS that these monies received are not taxable wages, but reimbursements. Thus, it’s critical to keep documentation for the IRS. This is where proper bookkeeping and recordkeeping is essential.
Examples of common items that could be reimbursed through an accountable plan include seminars and educational events (including travel to and from these events and meals) and healthcare premiums. With a medical reimbursement plan, a C-corporation can deduct 100% of the reimbursed medical expenses of its employees. This is significantly better than the limit for what medical expenses an individual can deduct, which is currently at 10%. It’s important to note, however, that if your C-corporation has employees, the medical reimbursement plan must be offered to all employees.
C-corporations are powerful entities in part because they are not subject to hobby loss rules. C-corporations are entities that do not have to prove a profit motive.
If you have a C-corporation and file Form 2553, you can be treated as an S-corporation. S-corporations are hybrid entities that arguably offer the best of both worlds (partnerships & C-corporations).
S-corporation income flows through to the owners, and S-corporations are not required to have more than one owner/shareholder. So, you can have flow-through taxation with an S-corporation but still receive many of the benefits of traditional C-corporations.
On the tax side, S-corporations can access corporate deductions. Additionally, S-corporations offer asset protection and corporate protection. S-corporations do file their own tax returns with Form 1120S, but it’s all going to end up flowing through to the owners.
One of the major benefits of an S-corporation is that its flow-through income is not subject to self-employment (SE) tax. The IRS is aware that this is one of the reasons people use S-corporations, however. To mitigate that, the IRS requires that shareholders pay themselves a reasonable salary from the S-corporation. Notice, though, that you still hold the cards. You can determine what a reasonable salary is (reasonably).
Distributions also become available when you use an S-corporation. You can take money from an S-corp and it’s not taxable as long as you have a salary that’s comparable. Otherwise, it could all be considered self-employment income.
Different Types of Business Entities
As you can see, there are a lot of different considerations that go into selecting an appropriate business entity. And this was only a broad overview — there are much more specific, nuanced, and nitty-gritty concerns with each entity type that aren’t covered here.
If you have questions about selecting the right business entity for your individual business, investing, and goals — or if you’d like an expert, no-cost review of your current business structure — schedule a complimentary Strategy Session with one of our certified Advisors today. On the call, you and a Senior Advisor will discuss the best business entity structure for you, tailor-made to your situation. You can schedule online or by calling 888.871.8535.