Metamorphosis      [i]

By now, most readers have heard about the benefits and pitfalls of “checking the box” or of failing to do so. Of course, I am referring to the election afforded certain unincorporated business entities to change their status for tax purposes. Thus, for example, an LLC with one or more members – which is otherwise treated as a disregarded entity or as a partnership – may elect to be treated as an association taxable as a corporation; an association that has one member may elect to be treated as an entity that is disregarded for tax purposes, while an association with at least two members may elect to be treated as a partnership.

Each of these elections triggers certain income tax consequences of which its owners have to be aware prior to making the election; for instance, an association that elects to be treated as a disregarded entity or as a partnership is treated as having undergone a liquidation, which may be taxable to the entity and to its owner(s).

Although incorporated entities are not eligible to check the box, they may nevertheless desire to change their tax status – i.e., the legal form through which they conduct business[ii]; for example, they may, instead, want to operate as a partnership; conversely, a partnership may desire to “incorporate.” The conversion of a corporation into a partnership constitutes a taxable liquidation, while the incorporation of a partnership may generally be accomplished on a tax-deferred basis.

Stemming Abuse

But what if a business wanted to preserve its flexibility to change its tax status by switching from one form of legal entity to another, depending upon the circumstances?

The IRS foresaw that the ability to change the tax status of a business whenever it suited the owners to do so may lead to abuse. Thus, the check-the-box rules provide that an eligible entity may not elect, as a matter of right, to change its status more than once within any five-year period; similarly, a corporation that loses or revokes its “S” corporation status may not, without the permission of the IRS, elect to again be treated as an S corporation for five years.

“Swapping” Bodies[iii]

A recent Tax Court decision involved a limited liability partnership (“LLP”) that actually shifted its business (“Business”) into a professional corporation (“PC”) – it did not check the box – then, about five years later, shifted it back to LLP. In making these shifts, the owners of these business entities – who remained the same – kept both entities in existence notwithstanding the transfers of Business between them.

Interestingly, the dispute before the Court did not involve the income tax consequences arising from the “conversion” but, rather, the overpayment of employment taxes by LLP and the underpayment of such taxes by PC.

In Year One, four individuals engaged in Business through LLP. In Year Two, they operated through LLP for only two weeks, at which point they commenced operations through newly-formed PC (a C-corporation).

Although LLP ceased conducting ongoing operations, it was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits related to LLP’s work.

PC conducted Business from that point forward through the end of Year Two. LLP paid wages to its employees for the first quarter of Year Two (“Quarter”), but the employment tax deposits it made for that period exceeded the wages paid.

The employees who were paid wages by LLP for the first two weeks of Quarter received the balance of their wages during Quarter from PC. Although PC’s general ledger recorded the employment tax deposits made, its payroll services provider that made the employment tax deposits, erroneously submitted them under LLP’s EIN.

The IRS credited LLP’s account for the employment tax deposits made by LLP; it also recorded that LLP timely filed a Form 941, Employer’s Quarterly Federal Tax Return. However, the IRS’s account for PC recorded no employment tax deposits or filings for Quarter.

The IRS’s account transcripts for LLP’s three remaining quarters for Year Two indicated that LLP had neither filed Forms 941 nor reported any employment tax liabilities for those quarters, while PC’s account transcripts for the same quarters indicated that PC had timely filed Forms 941 and made employment tax deposits for each quarter.

In Year Five, Business was again moved to LLP, while PC was kept alive in order to collect receivables, satisfy payables, and distribute profits relating to PC’s work. Hmm.

Tax Deficiency?

In Year Seven, the IRS notified PC that there was no record of PC’s having filed a Form 941 for Quarter. PC used its general ledger to prepare the Form 941, which reported the correct amount of employment tax due, and claimed a credit for employment tax deposits made, on the basis of entries in PC’s general ledger for wages paid and employment tax deposits made. The IRS assessed the employment taxes reported as due but did not credit PC with the employment tax deposits claimed.

PC thereafter sought to correct the Form 941 filed by LLP, claiming adjustments for LLP’s overpayment of employment taxes for Quarter based on the wages actually paid and the amounts actually owing thereon. PC also requested that a credit be applied to its employment tax liability for Quarter.

The IRS informed PC that a credit for LLP’s claimed overpayment could not be applied as requested because the period of limitations for claiming a refund had expired.

PC contended that the Quarter’s employment tax liability the IRS sought to collect had been previously paid by LLP, a related entity, which entitled PC to a credit, refund, setoff or equitable recoupment for the asserted liability.

PC explained that, through the error of its payroll service provider, PC’s employment tax deposits during Quarter had been remitted under the EIN of LLP, an entity through which the business had previously conducted its operations. PC further contended that PC should be credited with the Quarter’s deposits that had been erroneously submitted under LLP’s EIN through equitable recoupment.

In addition, PC tried to explain why both LLP and PC had been maintained as active entities during Year Two and thereafter, with each entity being used at various times to conduct the bulk of Business’s operations.

The IRS concluded that (i) PC had failed to sufficiently explain the continued active status of LLP, and (ii) because PC and LLP were both active entities, it would not be appropriate to allow PC to offset any of its employment tax liability with deposits LLP had made.

Equitable Recoupment

PC petitioned the Tax Court for review of the IRS’s determination. The issue for decision was whether PC was entitled to offset its unpaid employment tax liability for Quarter with the employment tax that LLP overpaid for Quarter.

“Long story short,” as they say, the Tax Court found that PC was entitled to offset the employment tax liability that the IRS sought to collect from it with the overpayment of employment tax made by LLP for the same period, the refund of which was time-barred. Without this offset, the Court stated, the IRS would have twice collected the employment taxes for Quarter arising from the payment of wages to the employees of Business: once from the deposits made under LLP’s EIN for Quarter, and a second time from the proposed levy on PC’s property.

The Court explained that the judicially-created doctrine of equitable recoupment applied to PC’s situation.[iv] In coming to that conclusion, the Court considered the documentary evidence submitted by PC regarding the organizational history of Business, including its alternating use of LLP and PC as its principal operating entity, with the other entity maintained for the purpose of collecting revenues and paying liabilities arising from past work. This alternating use, the Court observed, was substantiated with copies of each entity’s income tax returns for several years, demonstrating that the bulk of Business’s income was received through only one of the two entities in any given year.

According to the Court, when each entity’s general ledger for Quarter was compared to the IRS’s corresponding account transcripts, they conclusively established PC’s equitable recoupment claim. Specifically, the general ledgers demonstrated that PC was the source of the employment tax payments for Quarter that created LLP’s overpayment, and PC paid the wages that gave rise to the employment tax liability that was paid under LLP’s EIN.

Shape-Shifting, At Will?

The Court’s decision was all well and good for PC’s and LLP’s owners.

But what about the shifting of Business from LLP to PC, and then back to LLP? Specifically, what about the income tax consequences resulting from the “incorporation” of LLP and the “liquidation” of PC? The Court made no mention of these whatsoever, which begs several question.

Did the LLP liabilities assumed or taken subject to by PC exceed the adjusted bases of the assets “contributed” by LLP to PC? Did the fair market value of PC’s assets exceed their adjusted bases, or the owners’ adjusted bases for their shares of PC stock? The decision does not indicate whether LLP, PC, or their owners reported any gain on the transfer of “Business” between PC and LLP.

Indeed, was there any transfer of assets at all, other than a transfer of employees? Is that why the-then existing receivables and payables remained with LLP in Year Two and with PC in Year Five?

Did LLP’s/PC’s tangible personal properties remain in one entity, and were these leased or subleased to the other entity when Business was shifted to that entity? Was the real property they occupied leased or subleased between them? Was a market or below-market rate charged for the use or assignment? Or were these properties sold or exchanged for consideration?

What about projects that were ongoing at the time of the shift – how were these handled? What about the goodwill associated with Business – how was it transferred? Or did the goodwill reside with the individual owners of LLP and PC (so-called “personal goodwill”), and not with the entities?

Of course, these issues were not before the Court, but the “identity of interest” among PC, LLP, and their owners underpinned the Court’s decision. It is clear from the decision that LLP and PC operated a single Business, that their owners were identical, that the entities used the same name (but for the “PC” versus “LLP” designation), and that they employed the same individuals.[v]

What, then, was the impetus for the owners of LLP and PC to shift the operation of Business between the two entities? It wasn’t the nature of a particular project – for example, the complexity of the project, or the degree of liability exposure – after all, only one entity was active at any one time; the owners did not assign some projects to LLP and others to PC. Was there another business reason at work? Or was the shifting based upon some undisclosed tax considerations?

Whatever the reasons for LLP’s and PC’s actions, the owners of a closely held business should not think, based upon the underlying facts of the above decision, that they may freely, and without adverse tax consequences, shift the operation of a single business between two commonly-controlled entities simply by “turning off” one entity and “turning on” the other. The use of “successor” entities to a single business without a significant change in beneficial ownership of the business is an invitation to trouble with the IRS.

Indeed, even the allocation of projects among two or more commonly-controlled entities engaged in a single business may generate adverse tax results.

The owners should first consider why they would allocate projects – is it only for tax savings, or is there a bona fide business reason? For example, as mentioned above, does one entity engage in one aspect of a business, such as design, while another handles another aspect, such as construction? Or does one entity handle higher-end work, and markets or brands itself accordingly, while the other takes care of “lesser” jobs? Does one entity assume riskier projects and is insured therefor, while the other gets the plain-vanilla assignments?

Assuming there is a bona fide business reason for the allocation of work among the controlled entities, the owners will still have to consider how to allocate the resources of the business among these entities, and for what consideration; for example, if the equipment necessary for the completion of a project resides in an entity other than the one engaged in the project, how will the equipment be made available and at what price; what about employees and overhead, such as office space?

In every case, the owners of the related entities need to consider the business reason for the allocation of work to one entity as opposed to another; then they have to consider the tax consequences thereof and how to deal with them.


[i] Fear not, we’re talking tax, not Kafka.

[ii] By contrast, some entities may seek to change their legal form (for example, switching from a corporation to an LLC as a matter of state law), while maintaining their tax status. Thus, the merger a corporation into an LLC that has elected to be taxed as a corporation may qualify as an F-reorganization; the entity remains a corporation for tax purposes, but it is now governed by the state rules applicable to limited liability companies rather than those applicable to corporations.

[iii] Fear not, we’re talking tax, not “The Exorcist.”

[iv] The doctrine operates as a defense that may be asserted by a taxpayer to raise a time-barred refund claim as an offset to reduce the amount owed on the IRS’s timely claim of a deficiency, thereby preventing an inequitable windfall to the IRS. In general, a taxpayer claiming the benefit of an equitable recoupment defense must establish the following elements: (1) the overpayment for which recoupment is sought by way of offset is barred by an expired period of limitations; (2) the time-barred overpayment arose out of the same transaction, item, or taxable event as the deficiency before the Court; (3) the transaction, item, or taxable event was inconsistently subjected to two taxes; and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

[v] Courts may, in certain circumstances, permit a taxpayer to recoup an erroneously paid tax that the taxpayer did not pay himself. But the payor of the tax and the recipient of the recoupment must have a sufficient identity of interest such that they should be treated as a single taxpayer in equity.

Though LLP and PC were separate legal entities with distinct EINs during Quarter, each was owned by the same individuals during that period. Consequently, the burden of double taxation would be borne by the same individuals. Therefore, PC demonstrated sufficient identity of interest with LLP to allow PC to recoup the employment tax for Quarter that LLP overpaid.

 

 

Ah, December

As we near the end of the taxable year ending December 31, 2017, the thoughts of most people turn to holidays and family gatherings, feasting and celebrations, and reflecting, perhaps, on another year gone-by.

Not so for tax professionals.

Instead of “visions of sugar plums” dancing in their heads, these poor folk dream of proposed legislation, obsess over the effective dates of regulations, struggle to close year-end transactions and to implement last-minute tax planning, and prepare for the upcoming tax filing season.

Speaking of tax filings, there is a new filing obligation that should be of interest to U.S. tax professionals who advise foreigners with U.S. investments or U.S. business interests. This filing requirement went into effect for taxable years beginning on or after January 1st of 2017; thus, the first returns to be filed under the new requirement will be due in early 2018.

Specifically, if a domestic LLC is wholly-owned by one foreign person, and it is otherwise treated as a disregarded entity for tax purposes, then the LLC must comply with certain reporting and record maintenance requirements that were previously limited to foreign-owned U.S. corporations.

Entity Classification

In general, a business entity with two or more members is treated, for tax purposes, as either a corporation or a partnership, and a business entity with a single owner is treated as either a corporation or an entity disregarded as separate from its owner (“disregarded entity”).

Certain domestic business entities, such as LLCs, are classified by default as partnerships (if they have more than one owner) or as disregarded entities (if they have only one owner), but are eligible to elect for federal tax purposes to be classified as corporations.

Some disregarded entities are not obligated to file a return or to obtain an employer identification number. According to the IRS, the absence of a return filing obligation (and the associated record maintenance requirements), made it difficult for the IRS to implement and enforce the tax laws applicable to foreigners that invest, or operate a business, in the U.S. through as disregarded entity.

Information Reporting

Under the Code, a domestic corporation that is at least 25% foreign-owned (a “reporting corporation”) is subject to specific information reporting and record maintenance requirements.

A reporting corporation is required to file an annual return on IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, with respect to each “related party” (including, among others, the 25%-foreign shareholder) with which the reporting corporation has had any “reportable transactions” including, for example, sales, leases, services, rentals, licenses, and loans.

The Form 5472 for a tax year must be attached to the reporting corporation’s income tax return for such year by the due date (including extensions) of the return. A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation had a reportable transaction during the tax year.

The reporting corporation must also keep books and records that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of its transactions with related parties.

An Issue for the IRS

When a foreign-owned entity, such as an LLC, was classified as a corporation or a partnership for tax purposes, general ownership and accounting information was available to the IRS through the return filing and EIN application requirements.

Before 2017, however, when a single-member, foreign-owned, domestic LLC was treated as a disregarded entity for tax purposes, it was generally not subject to a separate income or information return filing requirement. Its owner was treated as owning directly the entity’s assets and liabilities, and the information available with respect to the disregarded entity depended on the foreign owner’s own return filings, if any were required.

Thus, if the LLC was wholly-owned by a foreign corporation, foreign partnership, or nonresident alien individual, generally no U.S. income or information return would have been required if neither the disregarded LLC nor its owner received any U.S. source income or was engaged in a U.S. trade or business.

Moreover, if the disregarded entity only received certain types of U.S. source income, such as portfolio interest or U.S. source income that was fully withheld upon at source, its foreign owner would not have had a U.S. return filing requirement.

The IRS found that even in cases when the disregarded entity had an EIN, as well as in cases when income earned through a disregarded entity had to be reported on its owner’s return (for example, income from a U.S. trade or business), it could be difficult for the IRS to associate the income with the disregarded entity based solely on the owner’s return.

The absence of specific return filing, and associated recordkeeping, requirements for foreign-owned, single-member domestic entities, and the resulting lack of ready access to information on ownership of, and transactions involving, these entities, made it difficult for the IRS to ascertain whether the entity or its owner was liable for any federal tax.

New Reporting Obligation

Thus, at the end of 2016, the IRS adopted a new regulation under which a domestic LLC, that is wholly-owned (directly, or indirectly through one or more other disregarded entities) by one foreign person, is treated as a domestic corporation (i.e., as an entity that is separate from its owner) for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) described above. Importantly, it does not alter the framework of the existing entity classification regulations, including the treatment of certain LLCs as disregarded for income tax purposes.

By treating an affected LLC as a foreign-owned domestic corporation, the LLC becomes a “reporting corporation.” Consequently, it is required to file a Form 5472 information return with respect to any “reportable transactions” between the LLC and its foreign owner or other foreign “related parties” (transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes) including, for example, sales, leases, services, rentals, licenses, and loans. It is also required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions. In addition, because the foreign-owned LLC has a filing obligation, it is required to obtain an EIN.

To ensure that a wholly-owned LLC reports all of its transactions with its foreign owner and other related parties, even if its foreign owner already has an obligation to report the income resulting from those transactions (for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business), the regulations specify, as an additional reportable category of transaction, any transaction to the extent not already covered by another reportable category. Thus, for example, contributions and distributions (both current and liquidating) are considered reportable transactions with respect to a “reporting LLC.”

Accordingly, any transaction between such an LLC and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the reporting and record maintenance requirements, even though, because the transaction involves a disregarded entity, it generally would not be considered a transaction for other tax purposes.

In order to facilitate the implementation of this reporting requirement, the reporting LLC is treated as having the same taxable year as its foreign owner, if the foreign owner has a U.S. return filing obligation. If the foreign owner has no U.S. return filing obligation, then the LLC is treated as having the calendar year as its taxable year.

Penalties

The penalty provisions associated with the failure to file the Form 5472 and the failure to maintain records will apply to reporting LLCs. For example, a penalty of $10,000 will be assessed against any reporting LLC that fails to file Form 5472 when due. The penalty also applies for a failure to maintain records as required. If the failure continues for more than 90 days after notification by the IRS, additional penalties will apply.

What Does It Mean?

Ah, the beginning of a new taxable year, and of a new era of transparency for many foreign-owned LLCs. What is one to do?

For starters, the U.S. professionals who advise these entities and their owners should alert them of the new reporting requirements, if they haven’t already done so. They should also be on the lookout for new Form 5472 instructions.

If a reporting LLC does not already have one, it must obtain an EIN as soon as possible. In connection therewith, the LLC will have to identify its “responsible party” (basically, the individual who controls the disposition of the LLC’s funds and assets), which means that the responsible party will itself have to obtain its own U.S. identification number (for example, an ITIN).

In addition, the LLC, its foreign owner, and their U.S. advisers will have to make certain that they have properly documented their 2017 reportable transactions, have maintained sufficient records to substantiate the accuracy of the information return to be filed by the LLC, and have implemented the appropriate internal procedures to ensure future compliance with the new reporting requirement.

Choice of Entity

One of the first decisions – and certainly among the most important – that the owner of a new business must make is the form of legal entity through which the business will be operated. This seemingly simple choice, which is too often made without adequate reflection, can have far-reaching tax and, therefore, economic consequences for the owner.

The well-advised owner will choose a form of entity for his business only after having considered a number of tax-related factors, including the income taxation of the entity itself, the income taxation of the entity’s owners, and the imposition of other taxes that may be determined by reference to the income generated by, or withdrawn from, the entity.

In addition to taxes, the owner will have considered the rights given to her, the protections afforded her (the most important being that of limited exposure for the debts and liabilities of the entity), and the responsibilities imposed upon her, pursuant to the state laws under which a business entity may be formed.

The challenge presented for the owner and her advisers is to identify the relevant tax and non-tax factors, analyze and (to the extent possible) quantify them, weigh them against one another, and then see if the best tax and business options may be reconciled within a single form of legal or business entity.

The foregoing may be interpreted as requiring a business owner, in all instances, to select one form of business entity over another; specifically, the creation of a corporation (taxable as a “C” or as an “S” corporation) over an LLC (taxable as a partnership or as a disregarded entity) as a matter of state law. Fortunately, that is not always the case. In order to understand why this is so, a brief review of the IRS’s entity classification rules is in order.

The Classification Regulations

A business entity that is formed as a “corporation” under a state’s corporate law – for example, under New York’s business corporation law – is classified as a corporation per se for tax purposes.

In general, a business entity that is not thereby classified as a corporation – such as an LLC – can elect its classification for federal tax purposes.

An entity with at least two members can elect to be classified as either a corporation (“association” is the term used by the IRS) or a partnership, and an entity with a single owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner.

Default Classification

Unless the entity elects otherwise, a domestic entity is classified as a partnership for tax purposes if it has two or more members; or it is disregarded as an entity separate from its owner if it has a single owner. Thus, an LLC with at least two members is treated as a partnership for tax purposes, while an LLC with only one member is disregarded for tax purposes, and its sole member is treated as owning all of the LLC’s assets, liabilities, and items of income, deduction, and credit.

Election to Change Tax Status

If a business entity classified as a partnership elects to be classified as a corporation, the partnership is treated, for tax purposes, as contributing all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter, the partnership liquidates by distributing the stock of the corporation to its partners.

If an entity that is disregarded as an entity separate from its owner elects to be classified as a corporation, the owner of the entity is treated as contributing all of the assets and liabilities of the entity to the corporation in exchange for stock of the corporation.

An election is necessary only when an entity chooses to be classified initially (upon it creation) as other than its default classification, or when an entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification until the entity makes an election to change that classification.

In order to change its classification, a business entity must file IRS Form 8832, Entity Classification Election. Thus, an entity that is formed as an LLC or as a partnership under state law may file Form 8832 to elect to be treated as a corporation for tax purposes.

Alternatively, an LLC or a partnership that timely elects to be an S corporation (by filing IRS Form 2553) is treated as having made an election to be classified as a corporation, provided that it meets all other requirements to qualify as a small business corporation as of the effective date of the election.

Electing S Corporation Status – Why?

Most tax advisers will recommend that a new business be formed as an LLC that is taxable as a pass-through entity (either a partnership or a disregarded entity). The LLC does not pay entity level tax; its net income is taxed only to its members; in general, it may distribute in-kind property to its members without triggering recognition of gain; it may pass through to its members any deductions or losses attributable to entity-level indebtedness; it can provide for many classes of equity participation; it is not limited in the types of person who may own interests in the LLC; and it provides limited liability protection for its owners.

In light of these positive traits, why would an LLC elect to be treated as an S corporation? Yes, an S corporation, like an LLC, is not subject to entity-level income tax (in most cases), but what about the restrictive criteria for qualifying as an S corporation? An S corporation is defined as a domestic corporation that does not: have more than 100 shareholders, have as a shareholder a person who is not an individual (other than an estate, or certain trusts), have a nonresident alien as a shareholder, and have more than one class of stock.

The answer lies, in no small part, in the application of the self-employment tax.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner.”

That being said, any guaranteed payments made to a limited partner for services actually rendered to or on behalf of the partnership, “to the extent that those payments are established to be in the nature of remuneration for those services . . . ,” are subject to the tax.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. The “limited partner exclusion” was intended to apply to those partners who “merely invest” in, rather than those who actively participate in and perform services for, a partnership in their capacity as partners.

A partnership cannot change the character of a partner’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

Instead, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive business.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

Unfortunately, the Code does not define the term “limited partner,” though the IRS and the courts have, on occasion, interpreted the term as applied to the members of an LLC; specifically, based upon these interpretations, the level of a member’s involvement in the management and operation of the LLC will be determinative of her status as a “limited partner” and, consequently, of her liability for self-employment tax.

S Corporations

The shareholders of an S corporation, on the other hand, are not subject to employment taxes in respect of any return on their investment in the corporation – i.e., on their pro rata share of S corporation income – though they are subject to employment taxes as to any wages paid to them by the corporation.

For that reason, the IRS has sought to compel S corporations to pay their shareholder-employees a reasonable wage for services rendered to the corporation. In that way, the IRS hopes to prevent an S corporation from “converting” what is actually compensation for services into a distribution of investment income that is not subject to employment taxes.

Why Not Incorporate?

If the self-employment tax on an owner’s share of business income can be legitimately avoided by operating through an S corporation – except to the extent it is paid out as reasonable compensation for services rendered by the owner to the corporation – why wouldn’t the owner just form a corporation through which to operate the business?

The answer is rather straightforward: because tax planning, although a very important consideration, is not necessarily the determinative factor in the choice-of-entity decision.

There may be other, non-tax business reasons, including factors under state law, for establishing a business entity other than a corporation.

For example, in the absence of a shareholders’ agreement – which under the circumstances may not be attainable – shares of stock in a corporation will generally be freely transferable, as a matter of state law; on the other hand, the ability of a transferee of an ownership interest in an LLC to become a full member will generally be limited under state law – in most cases, the transferee of a membership interest in an LLC will, in the absence of a contrary provision in the LLC’s operating agreement, become a mere assignee of the economic benefits associated with the membership interest, with none of the rights attendant on full membership in the LLC.

With that in mind – along with other favorable default rules under a state’s LLC law, as opposed to its corporate law – and recognizing the limitations imposed under the Code for qualification as an S corporation, a business owner may decide to form her entity as an LLC in order to take advantage of the “benefits” provided under state law; but she will also elect to treat the LLC as an S corporation for tax purposes so as to avoid entity-level income tax and to limit her exposure to self-employment tax.

In this way, the business owner may be able to reconcile her tax and non-tax business preferences within a single legal entity. The key, of course, will be for both the owner and her tax advisers to remain vigilant in the treatment of the LLC as an S corporation. The pass-through treatment for tax purposes will be easy to remember, but other tax rules applicable to corporations (such as the treatment of in-kind distributions as sales by the corporation), and to S corporations in particular (such as the single class of stock rule), will require greater attention, lest the owner inadvertently cause a taxable event or cause the LLC to lose its “S” status.