Too often professionals do not take the time to consider the impact to the client when recommending the proper choice of entity. The trend in the last five years or so has been to make most new entities LLCs taxed as sole proprietorships or partnerships. The attorney has a brief conversation with the client and LLC documents are drafted, filed, and a tax identification number is applied for. So what’s wrong with that?
Each type of entity, S-Corp, C-Corp, Partnership, and LLC has its own pros and cons. Each type may be the perfect solution, and each type could be the worst possible solution. Most often the entity chosen is not very well thought out. My attempt here is not to cover all possible scenarios but to support the argument that it is important to take some time, ask questions, and to help the client make the best choice.
Questions to consider when choosing the right entity type:
Does the client want to draw a paycheck and have tax withholdings?
Is the client going to make estimated tax payments?
What is the long- term strategy for the organization? ( ie: how will the ownership interest be passed on to subsequent owners/generations?)
Will the entity have operating profits or losses?
Will the client be able to shelter some income from SE tax?
Does the entity have tax credits or pension plans that might come into play?
Each of these questions could lead one to choose an entity that is the best fit. Consider the following examples:
Restaurateur client proposes to open EAT. The client’s dream is to have the best restaurant in central Maine and his market analysis suggests that sales will reach $1,200,000.with net income of $80,000. The owner would like to take a salary of $50,000 annually. Based upon budgeted projections, the FICA Tip Credit is expected to be $19,000 annually.
EAT should probably be an S-Corporation. The flow through income and wages to the owner would be almost offset by the FICA Tip Credit. The tax consequences of choosing an LLC would create more Self-employment tax because the flow through income ($80,000) would be subject to SE tax as would the adjustment for the FICA Tip Credit ($19,000). Thus, total income subject to additional FICA tax would be $99,000. Additionally, SE taxes cannot be offset by the tip credit and therefore….Advantage S-Corp.
Lawyer friends want to start a new law firm (LAW 1). Initially, there will be three partners with others buying in over time. Income is to be split based upon book of business annually.
LAW 1 should probably be set up as an LLC. Although subject to higher SE tax, the LLC formation will allow partners to take advantage of flexibility of profit sharing and will also allow for 754 elections to be made as new partners are admitted into the practice. Even though the current SE tax impact will result in more tax the flexibility and potential for 754 election make the….Advantage LLC.
In summary, the correct choice of entity may not always be the best tax plan for today. Ordinarily earnings that flow through an S-Corp do not have FICA tax consequences while those flowing through an LLC might. Other considerations could include, basis for deducting losses, basis step up or ease of transferring ownership. When selecting the best entity type for your client, take the time to understand all of your client’s future objectives.
Jamie Boulette, CPA, Director