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LLCs, S CORPs and 'C's, OH MY

January 24, 2006

Yesterday's post on Limited Liability Companies (LLCs) and S corporations triggered a fun exchange with Ryan Ellis of Americans for Tax Reform. It is reproduced, with Ryan's kind consent, in the extended entry below.

Ryan writes: I was interested to see Hoyt's data and your observations on LLCs vs. S-corps. Here's a question, though-how do you account for LLCs that use check-the-box to be treated as entities other than sole props/general partnerships? Acme Company, LLC can appear as easily on a Schedule C, a 1065, an 1120, or an 1120-S. I know for my clients, I tend to advise filing an LLC and then doing check the box if they want C-corp or S-corp treatment. The LLC gets the legal severability, and the tax treatment is a simple election (or not) after that.

I respond:Thanks for the note. You raise good questions about LLCs as disregarded entities or check-the-box corporations. I read the Hoyt piece as a discussion of LLCs vs. S corporations as tax-filing entities - that is, a 1065-filing LLC vs. an 1120S-filing corporation - and framed my thoughts accordingly.

In your broader context, LLCs are very useful. I have a lot of LLCs sitting as disregarded entities under other taxpayers. In that case, though, it's not a discussion of LLCs vs. something else; it's how an LLC can be used as part of another structure.

I'm a bit leery of using check-the-box LLCs as S corporations, though, because the lawyers often put things in the LLC operating agreement that cause single-class-of-stock problems. Not insurmountable, but it's nice to not have to explain the problem to the attorney and the client, so I tend to go with a per-se corporation where I want an S corporation.

Ryan then writes:Most of my clients don't have the single class of stock issue-they're just small businesses looking to streamline filing and minimize FICA/SECA. For them, the avoidance of corporate charters, minutes, a board, etc. is worth it. Pay yourself a reasonable salary and call it a day.

My advice for most clients, actually, is to form an LLC and do a check-the-box as a C-corp. This way, the client can take advantage of the $50000 15% corporate rate and the $30000/$60000 15% personal rate. Reasonable salary is no longer an issue, and the health fringe is more straightforward. Double taxation is usually avoided by setting up leasing agreements on home offices (which are claimed on the Sch. E). S-corp owners are normally forced into higher marginal tax brackets than they have to be.

Since it's my blog, I take the last word:

Your advice to "most clients" is apt in many circumstances - especially where you are dealing with a single-owner non-professional enterprise that is unlikely to grow out of the up to $250,000 - $300,000 income range, and with a legitimate use for a home office or a non-abusive related party rental. The 15% dividend and capital gain rate helps, but I'm not willing to bank on it under current political circumstances.

I hate to default into the C corporation format, though, at least in my client base. The 15% bracket is ultimately a deferral, not a permanent savings, until (and if) the 15% dividend rate becomes permanent. As the business grows, C corporations tend to involve more need to "plan around" the format, tempting the taxpayer to diddle dangerously with related party transactions. These get to be expensive, increase tax risk, and divert attention from the business - a sort of "friction" inherent in the C corp format. With multiple owners, these problems expand exponentially. For clients with real growth potential, the C corporation becomes a straitjacket. These issues lead most of my clients to opt for some sort of pass-through.

I lose no sleep over S corporation compensation issues, and I won't as long as the IRS doesn't come after non-abusive situations. The excess compensation problems with C corporations, in contrast, are real and well documented. The choice-of-entity decision isn't usually so close that fringes becomes a tiebreaker.

Given a different client base, though, I would probably have more C corporations.

Of course, every client is different, and so you have to be willing to adapt and improvise. I thank Ryan for his contribution. I have cleaned up a little hurried (read - poorly written) verbiage in my responses.

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