Why an LLC and not just an S corporation?

Because LLCs are either taxed as sole proprietors, partnerships or corporations, this adds to the confusion and understanding as to what type of entity a business is operating under.  I have been asked several times, “if we, as members of an LLC, elect to be tax as an S corporation and we are deemed to have transferred assets for stock of an S corporation, why wouldn’t we have just set up an S corporation from the beginning.”  This is a great question.  First remember that in Florida business entities are formed under state laws but are taxed according to federal tax codes.  Therefore, if the S corporation election is made the entity is still considered an LLC for state legal purposes.  State laws would cover topics such as piercing the corporate veil, charging orders available to creditors, and liability protection.  I am not an attorney so these topics should be discussed with your corporate legal professional.  However, just to touch on a few items, Florida Legislature often applies existing corporate law regarding piercing the corporate veil to determine when an LLC’s veil of limited liability should be pierced and the individual members held responsible for the torts and contractual obligations of the LLC.  However, because LLC’s are relatively new entities, Florida courts have been reluctant to pierce the LLC veil and will typically only do so when the LLC is considered a sham, instrumentality, or alter ego of its principals and was formed or used to further improper conduct or to perpetrate a fraud.

Charging order protection of an LLC.

The “charging order” of a creditor offers another layer of protection for an LLC member.  A charging order provides a creditor with the rights of an assignee, which entitles a creditor to receive distributions to which the debtor-owner would otherwise have been entitled.  However, creditors cannot vote on business matters, inspect or copy business records, nor exercise any of the debtor-owner’s rights with respect to the management of the business.  Owners of a corporation do not have this similar benefit; their creditors are not limited in their remedies to a charging order.  It is also believed that the creditor-owner of an LLC may be subject to tax on a phantom income.  Since they are considered owners for tax purposes, the creditor-owner would be subject to tax on the assigned portion of income regardless of whether the profits have been distributed.  This obviously makes LLC ownership less attractive to creditors for debt collection.

In Summary

Initially setting up an entity as an LLC and simultaneously electing to be tax as an S corporation through the filing of Form 2553 by the LLC members, state law protection and the added pass-through taxation benefits of an S corporation are combined. The entity, therefore, is both an LLC for state protection and legal concerns and an S corporation for federal income tax purposes.  Understand who you are talking to or the topic of the discussion when voicing what type of entity classification your business is operating under.

Care should be taken when writing the by-laws of the LLC to include provisions that would not disqualify the entity from being classified as an S corporation from such actions as allowing more than one class of stock.  A second class of stock would make the LLC ineligible to be taxed as an S corporation.  Although the legal ramifications should be discussed with an attorney, this combination of entities offers asset protection, limited liability, and the lowest pass-through taxation benefits for owners employed by the business. 

There are many other tax and legal steps that should be considered when deciding on the proper business entity and tax classification and should be discussed with your accountant and attorney.

Before you start thinking you are not an employee, you are self employed, let me clear up an issue.  If you are a small business owner, whether you are an S corporation or an LLC that chose to be taxed as an S corporation, you are not self employed.  In this situation you wear two hats.  You are an owner and you are an employee.  Tax codes will generally guide you to being treated as an employee first and then as an employer.  For example, tax laws regarding withdrawals from your S corporation would first ask, are you, as the employee, getting paid a “reasonable compensation” for your work as an employee?  If so, and only until you are, you may be able to take non-taxable distributions from your S corporation.

Examining the tax codes regarding Home Office expenses, you are also first considered an employee before you are the employer or owner.

Corporate Office in Home

Now let’s look at Home Office expenses when your company’s office is in your principal residence.  I have been asked several times, “can’t I just have my S corporation pay me rent”?  Examining what the IRS Codes say, Section 280A(c) basically explains that certain business use rental expenses are not deductible which are attributable to the rental of the dwelling unit (your house) by the taxpayer (you as the employee) to his employer during any period in which the taxpayer uses the dwelling unit (or portion) in performing services as an employee of the employer.  However, code section 162(a)(3) states your corporation can deduct the rental payments made to you as the employee.

This basically states that if you rent your Home Office to your S Corporation you, as the employee cannot deduct any expenses attributable to that rent, or that portion of the house, to offset the rental income.  Therefore, you would be lowering your S corporation income and increasing your personal income.  There generally is no benefit to this transaction, especially considering the State of Florida will want their seven percent sales tax on the rental of commercial property.  There may be areas that it could be beneficial to transact business in such a matter, however, that would be based on individual situations and would need to be discussed one on one.

So what can you do?

The goal now is to qualify the expenses of your Home Office as a “Working condition fringe”.  Section 132(d) defines a working condition fringe as property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under Section 162 or 167.  Other stipulations would require the employer to have an “accountable plan” established by the corporation to reimburse certain expenses paid by your employees (another discussion).

How does this work?

This would generally mean your corporation can reimburse your employee (you) for certain expenses directly related to the Home Office and paid by you as the employee.  These expenses would generally include repairs and supplies.  Another form of deduction would include certain expenses related to the portion of your house that is used for the business, such as utilities and insurance.

In summary

If your S corporation pays you, the employee, a reasonable salary, establishes an accountable plan to reimburse employees for deductible business expenses paid by the employee, your S corporation may be able to deduct Home Office expenses reimbursed to you.  Since these payments are a reimbursement of business expenses you personally paid, the payments to you are not included as income on your personal return.  Therefore, the corporation benefits from the rental expenses and you are able to pull out non-taxable income from your corporation.  Remember, you must also qualify your Home Office for legitimate business purposes for any of this to work.

1. Start gathering your records – Round up any documents or forms you’ll need when filing your taxes: receipts, canceled checks and other documents that support income or deductions you’re claiming on your return.
2. Be on the lookout – W-2s and 1099s will be coming soon; you’ll need these to file your tax return.
3. Use Free File – Let Free File do the hard work for you with brand-name tax software or online fillable forms. It’s available exclusively at http://www.irs.gov. Everyone can find an option to prepare their tax return and e-file it for free. If you made $58,000 or less, you qualify for free tax software that is offered through a private-public partnership with manufacturers. If you made more or are comfortable preparing your own tax return, there’s Free File Fillable Forms, the electronic versions of IRS paper forms. Visit www.irs.gov/freefile to review your options.
4. Try IRS e-file – After 21 years, IRS e-file has become the safe, easy and most common way to file a tax return. Last year, 70 percent of taxpayers – 99 million people – used IRS e-file. Starting in 2011, many tax preparers will be required to use e-file and will explain your filing options to you. This is your chance to give it a try. IRS e-file is approaching 1 billion returns processed safely and securely. If you owe taxes, you have payment options to file immediately and pay by the tax deadline. Best of all, combine e-file with direct deposit and you get your refund in as few as 10 days.
5. Consider other filing options – There are many different options for filing your tax return.You can prepare it yourself or go to a tax preparer.You may be eligible for free face-to-face help at an IRS office or volunteer site.Give yourself time to weigh all the different options and find the one that best suits your needs
6. Consider Direct Deposit – If you elect to have your refund directly deposited into your bank account, you’ll receive it faster than waiting for a paper check.
7. Visit the IRS website again and again – The official IRS website is a great place to find everything you’ll need to file your tax return: forms, publications, tips, answers to frequently asked questions and updates on tax law changes
8. Remember this number: 17 – Check out IRS Publication 17, Your Federal Income Tax on the IRS website. It’s a comprehensive collection of information for taxpayers highlighting everything you’ll need to know when filing your return.
9. Review! Review! Review! – Don’t rush. We all make mistakes when we rush. Mistakes will slow down the processing of your return. Be sure to double-check all the Social Security Numbers and math calculations on your return as these are the most common errors made by taxpayers.
10. Don’t panic! If you run into a problem, remember the IRS is here to help. Try http://www.irs.gov or call toll-free at 800-829-1040.

Source:  IRS.gov / IRS TAX TIP 2011-01, January 03, 2011

1. Form W-4 (2011): The W-4 form is necessary for employers to withhold the proper amount of federal income tax from your paycheck. It is important, the IRS points out, to fill out a new W-4 when financial or personal situations change. In fact, although it is not required, the IRS does suggest filling out a new W-4 form for your employer each year, to account for your current financial/personal situation.
2. Form W-9: The W-9 form allows required individuals to obtain an individual’s correct taxpayer identification number (TIN) for income reporting purposes. As examples, the IRS lists income paid to you; real estate transactions; mortgage interest you paid; acquisition or abandonment of secured property; cancellation of debt; and contributions you made to an IRA. Many people associate the W-9 form with an employer, which is a valid use for the form but, as one can see from the IRS examples, the W-9 form is necessary in a variety of situations.
3. Form 1040: The 1040 form is used for filing the individual tax return.
4. Form 1040X: The 1040X form is used to amend an individual tax return.
5. Form 4506-T: The 4506-T form is a request for a transcript of a tax return. The transcript can be sent to the person designated on the tax return, or can be sent to a third party. The transcript, the IRS notes, is different from an actual copy of one’s tax return, which can be requested with a 4506 form.