LLC vs. S-Corporation, Round 1

When setting up a business and deciding on entity type, most people are looking for 1) liability protection and 2) tax savings – specifically lowering self-employment tax liability.  For small businesses, the two best options are the LLC or the S-Corporation, and many tax or legal professionals seem to advocate for one team or the other so it is hard to know what entity is truly best for your business.  Well, I am not your advisor and I have been on both teams, so hopefully I can provide you with some balanced information and after a couple rounds, hopefully we will have a winner for your business…

Will the business own appreciating property like real estate?

If your business has anything to do with real estate rentals or owning and managing commercial or residential property, then LLC is the early winner.  This is vitally important – you should never put real estate into a corporation.  If a CPA or tax practitioner recommends this for a new small business, I would consider it malpractice.

Basically, if you put real property into an S-Corporation, then you are going to have a taxable event if you transfer it out of the corporation in the future and you will pay tax based on the fair market value of the property at that time.  I could tell you some horror stories on this issue, but trust me – if you have a residential or commercial property, put it in an LLC.
LLCs are perfect for real estate as you can move the property in and out of the entity without any taxable events.  Plus, they are much easier to setup, administer, and report for tax purposes.  Even better, if you have one owner, you can use the single-member LLC for your real estate and then the tax reporting is simplified so that you only have to complete a Schedule E as part of your personal return.

How many owners will the business have?

This is another important question to look at upfront, as it can result in a knock out in round one.  If you will be the sole owner of the business, then your options are limited to the following:

Single-member LLC (SMLLC)

The only LLC offering for the single-owner business is a great option for easy setup, administration, and tax reporting; however, it is going to cost you in the form of self-employment tax.  To the IRS, The SMLLC is no different than a sole proprietorship – in fact, the SMLLC is reported on Schedule C just like a sole proprietorship.  Unfortunately, this means that you will pay self-employment tax (15.4%) on the entire amount of your net taxable earnings.  This can really add up – especially if you are a consultant with few expenses and/or minimal capital asset needs.  After a few years of paying a hefty tax bill, most business owners are willing to put up with some extra administration and tax prep costs in exchange for a much lower tax bill via use of the S-Corporation while paying themselves a reasonable wage.

S-Corporation

The big winner for single-owner businesses is clearly the S-Corporation as most business owners can end up saving thousands.  With an S-Corporation, you do not pay self-employment tax on the earnings, BUT the owner must pay himself a “reasonable” salary, which means you are paying payroll taxes on the Federal and state level.  Usually, if you sit down with a CPA and lay this all out, they should be able to give you a ballpark of your tax savings each year; however, there are costs related with this:

  • Legal costs – it is not cheap to setup, but I would never suggest a D.I.Y for an S-Corporation.  Get it setup right and avoid legal problems later.
  • Accounting Fees – keeping your accounting data on a spreadsheet may not cut it anymore – especially if you use a lot of credit cards and loans.  Be prepared to pay a bookkeeper or an accountant to get your books setup right so that the tax preparation goes smoothly.
  • Tax Prep fees – S-Corporation returns require much more work and typically range from $750 – $2000 or higher depending on complication.  Plus, you now have to file quarterly payroll tax returns and payroll to process, which can run you about $95/quarter even with one employee using ADP, Paychex, of your CPA.

If your savings are still substantial after factoring in these costs, then you should definitely go with the S-Corporation, but make sure you have a good lawyer and a good CPA that you like as you will be talking to them frequently for the first few years.

Well, round 1 is in the bag and we are tied at 1 a piece.  In round 2 we will deal with issues for businesses with more than owner.

Just remember – never choose an entity for your business without consulting a CPA and lawyer as every situation and business is unique.  Give me a call at 503.224.8844 if you need a CPA or a lawyer to help you with your new business.

Self Rental Recharacterization

We have had passive activity rules for over 20 years and passive income recharacterization rules for close to 15 years, and it is surprising that there is still a lot of confusion and bad advice out there.  In paticular, self-rental income and recharacterization are a prime example – especially for business owners who lease real property to their business.

Let me setup a typical scenario to explain this:

Bob owns and materially participates in a successful contracting business organized as an S-Corporation, which leases a building and storage area owned by Bob personally.  Bob has the building and storage facility setup in a single-member LLC, he has a written lease agreement, and he pays a reasonable amount of rent from the corporation to the LLC.

Now, Bob also has five residential rental properties that he reports on his personal return, and on average the properties turn net losses because of high turnover and the large mortgages on the properties.  For simplicity sake, lets assume Bob has not filed any special elections and has an adjusted gross income over $150k.

Under passive activity income rules, the net losses from the rentals are not currently deductible on Bob’s individual tax return as he has no passive income to offset the losses and he is not allowed the special allowance of $25k in residential real estate losses because his AGI is over $150k.  These losses carryforward until Bob has a good year and receives some passive net income from the properties or sells them – otherwise the losses are kept separate from from the income Bob receives from his S-Corporation.

This has been a frustration for many taxpayers who have plenty of net income from their main business that they have to pay tax on and passive net losses from rental real estate that they cannot deduct or offset against that taxable income.  From 1987 to 1994, many taxpayers like Bob talked to their accountants and found that if they increased the rent the corporation paid them for the lease of the business facility, they could offset the net passive losses from the rental properties and essentially get to deduct all the losses against the active income from the corporation.  This worked great and was a fairly strong strategy.  Even shareholders who did not own property and only rented office space for their business would renew their leases in their personal name and them sublease to the corporation at a much higher amount – basically whatever was needed to cover the rental real estate losses.

However, this “loophole” was closed in 1994 by Regs. §§1.469-2(f)(6) and several court cases and “recharacterization” was officially born.  For self-rented property where the property was rented to active business, the net rental income from that lease became active and not passive, which means that it could not be offset against other passive losses.  For Bob in our example, this means that he cannot offset the net rental income from his facilities lease to the corporation against the passive losses from his residential rental properties.  The once great strategy is no longer plausible and we are back to taxable income from the corporation and passive net losses that are not currently deductible.

Why do I bring this up 15 years later?  Well, sadly many accountants and CPAs out there still use the pre-1994 strategy of offsetting the lease from the corporation against passive net losses from other rental real estate.  Some are aggressive and put more merit in prior dealings with IRS auditors and their ability to argue, while others may just be careless and uninformed.  Regardless, small business owners who also have rental real estate need to be aware of this issue and have a basic understanding of the rules as blaming your tax preparer is not going to get you off the hook with an IRS auditor.  In fact, talk to your CPA or accountant, ask questions, and make sure you understand the positions taken on your return.  Tax law is very complicated and often very dull, but in this case it is fairly clear and an incorrect position can result in a large IRS audit adjustment.

If you have any questions regarding your specific situation with passive net losses and recharacterization of self-rental property, feel free to email me to find out more about our consulting services.