April 18, 2017

Business owners, rejoice! A Tax Court victory could affect the way you’re taxed

For quite some time, owners of businesses structured in any partnership form besides limited partnerships – including LLCs – were subject to self-employment tax on 100 percent of their allocable income if the owner worked for the business.

It is a common practice for LLCs to compensate working members for their service with a guaranteed payment, which is comparable to a salary, and then that person would also receive his allocable share of the LLC’s profits.

Most LLCs and tax preparers thought it was reasonable to assume that only the guaranteed payment – the money they received for doing the work, rather than owning the business – would be subject to self-employment tax. However, the Tax Court and the IRS have long disagreed and said that 100 percent of whatever guaranteed payments and profits are allocated to the owner are subject to self-employment tax. Limited partnerships have a specific statutory exception to this rule.

Taxpayers got their first big victory in this area on January 17, 2017, when the Tax Court sided with a taxpayer by the name of Stephen Hardy. The ruling finally said that business owners are allowed to get returns as investors, so they are only subject to self-employment tax on whatever would be considered reasonable compensation for working at the business. The rest is not subject to self-employment tax.

While this is certainly a big win for taxpayers, there are some nuances to be aware of. LLCs that are service companies, such as law firms, likely make a profit from the personal services of their owners, and it’s difficult to distinguish income earned for working at the LLC from income received as an owner.

The recent Hardy decision is an opportunity for business owners to reevaluate their businesses’ structure. With that in mind, here are the four most common structures and some information about each of them.

1. LLC

Generally, this is the most popular way to structure a business because it combines the benefits of pass-through taxation and flexibility in compensating owners typically found in partnerships, and the liability protection and freedom to participate in management usually associated with corporations. Owners avoid double-taxation as they would in a partnership, yet their liability is limited to the company’s assets unless they personally guaranteed entity debt. Lastly, they are free to participate in management without fear of losing their limitation on liability.

2. General partnerships/limited partnerships

Both have the flexibility discussed above and are taxed the same way as LLCs, except limited partnerships have a specific statutory exemption from self-employment tax. In general partnerships, all partners’ personal assets are completely at risk for liabilities and debts of the partnership, which makes them less desirable than LLCs. Limited partnerships must have a general partner that is similarly liable, but the limited partners are protected as long as they do not participate in management of the business. Clever lawyers found ways to avoid these pitfalls, of course, but it was these complications that caused states to develop and enact the laws for LLCs.

3. S corporations

S corporations are pass-through entities similar in most ways to LLCs, but with some notable exceptions. People who own businesses structured as S corporations can work for the entity and are considered employees. They receive salaries and W-2s just like any other employee, and only the income reported on the W-2 is subject to employment tax. The S corporation deducts that salary just as it would with any other employee, and the shareholder’s share of the net profits are exempt from employment taxes. One caveat, however, is that each shareholder-employee’s compensation must be “reasonable,” or the IRS may seek to recharacterize profits as wages and subject them to employment tax.

S corporations are not as flexible LLCs and partnerships in how owners receive profit shares. In any corporation, profits must be distributed pro-rata in accordance with share ownership; whereas, partnerships and LLCs allow far greater flexibility.

4. C corporations

Unlike the three entities described above, C corporations are not pass-through entities and are recognized as separate taxpaying entities.

This structure creates two layers of taxes. The corporation itself is subject to taxation on profits at the corporate tax rate. Then, profit is taxed again at the personal level when it is distributed to shareholders as dividends. Smaller C corporations have often tried to avoid double taxation by paying year-end bonuses to shareholder-employees that bring the corporate profits to zero; however, the IRS has had recent success attacking this type of program and levied penalties on the ensuing deficiencies.

Want some more information about pass-through entities? Check out this blog post that details the advantages of setting your business up as a pass-through.

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