LLC
The Most Beautiful Summary of Trump’s Business Tax Cut. Period.
With some very broad brushstrokes, the Trump administration laid out its tax plan. It is still very early in the process, and skepticism about how much of the plan will survive negotiations should be maintained. This article will discuss a substantial reduction in taxes for business owners.
Very Major Overview
During the campaign, Donald Trump proposed cutting the maximum business tax rate to 15%. There was uncertainty as to whether this 15% maximum tax rate would also apply to pass through entities such as LLCs and S corporations. The uncertainty has been resolved as it is now clear that the 15% maximum tax rate applies to pass through entities and to sole proprietorships.
Tremendous and Beautiful Tax Cut
Example: John owns an S corporation and it has profit of $200,000. Assume John has other income and he is in the 35% tax bracket. Under current law, his tax liability on the $200,000 S corporation profit would be $70,000 (35% times $200,000). Under the Trump proposal, John’s maximum tax rate on the S corporation profit would be 15%, so his tax under the Trump plan would be $30,000.
Example: Same facts as above except John is a member of an LLC and his share of the LLC profit is $200,000. Again, his maximum tax rate under the Trump plan is 15%, so his tax on the share of the LLC profit would be $30,000.
You May Even Get Tired of Paying Lower Taxes and You’ll Say “Please, Please, It’s Too Much. We Can’t Take It Anymore.”
There has been an incentive for S corporation owners to minimize officer compensation because S corporation owners only incur payroll taxes on their payroll, not on the remaining business profit. The Trump plan would further encourage S corporation owners to minimize officer compensation because officer compensation would remain subject to higher income tax rates, while S corporation profit would be subject to the 15% maximum rate.
Example: Jennifer has an S corporation with $100,000 profit before officer compensation. Assume she has other income and is in the 35% tax bracket. She has officer compensation of $60,000 and S corporation profit of $40,000 after officer compensation.
Under current law, her tax would be:
Tax on Officer Compensation: $21,000 (35% times $60,000)
Tax on S corporation profit: $14,000 (35% times $40,000)
Total Tax $35,000
Under the Trump plan, her tax would be:
Tax on Officer Compensation: $21,000 (35% times $60,000)
Tax on S corporation profit: $6,000 (15% times $40,000)
Total Tax $27,000
Joan prefers paying tax at the 15% tax rate so she reduces her payroll to $40,000 (leaving S corporation profit of $60,000).
Under Trump plan with officer compensation reduction, her tax would be:
Tax on Officer Compensation $14,000 (35% times $40,000)
Tax on S corporation profit: $9,000 (15% times $60,000)
Total Tax $23,000
Joan saves $4,000 by reducing her higher-taxed payroll and increasing her S corporation profit that is taxed at the 15% maximum rate.
There is already incentive for S corporation owners to minimize officer compensation because officer compensation is subject to payroll taxes (generally 15.3% FICA plus unemployment taxes) while S corporation profit is not subject to payroll taxes. The Trump plan increases the incentive to minimize officer compensation.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Where an LLC Beats An S Corporation
LLC and S corporation owners can only deduct losses to the extent of their basis in the business. Additionally, LLC and S corporations can generally take tax-free distributions out of the business to the extent of their basis.
What is Basis?
While basis is a critical concept in tax law, it is not defined in the Internal Revenue Code or in Treasury regulations. Basis is basically your investment in a business (i.e., the amount you “put into” the business). To generate basis, you have to incur some type of actual economic outlay. You cannot deduct losses in excess of your basis in the business. Any distributions that exceed your basis in the entity are taxed as capital gains. Basis is therefore advantageous and should generally be maximized.
Owners of LLCs and S corporations can generate basis by contributing cash, property, or providing services to the entity (although contribution of services will generally be taxable). Owners of both types of entities can also generate basis by loaning funds directly to the entity.
Different Basis Rules for S corporations and LLCs
However, LLCs and S corporations differ in how they treat loans from third parties (e.g., bank loans). LLCs allow their owners to increase their basis for their shares of third party debt. The shares of debt allocated to each member are based on whether the debt is recourse or nonrecourse.
Nonrecourse debt is debt that owners are not personally responsible for—the lender’s only remedy is to repossess any assets securing the debt (they cannot collect any deficiency from the owners). Nonrecourse debt tends to involve real estate.
Recourse debt is debt that owners are personally responsible for.
Recourse debt is allocated to owners that are personally responsible for the debt. For example, if one LLC member personally guarantees a debt and has no right of contribution from the other owners, that LLC member’s basis will be increased by the full amount of that debt. If all LLC members personally guaranteed the debt, each of their basis would be increased equally by their proportionate share of that debt.
Nonrecourse debt is allocated based on a complicated three-tier allocation method. Very basically, nonrecourse debt is allocated based on the member’s shares of profit.
S corporations only allow basis for loans made from owners to the S corporation; they do not allow owners to increase their basis for their shares of loans provided by third parties such as banks or other lenders. This is true even if the owners personally guarantee the debt.
Examples
Tim and Todd form an LLC. They each contribute $10,000 in cash to the LLC. Tim loans $5,000 to the LLC. The LLC borrows $20,000 from a bank that Tim and Todd personally guarantee.
Tim’s basis equals:
Cash contributed: $10,000
Personal loan to LLC: $ 5,000
Share of bank loan: $10,000
Total Basis: $25,000
Todd’s basis equals:
Cash Contributed: $10,000
Share of bank loan: $10,000
Total Basis: $20,000
If Tim and Todd instead formed an S corporation, their basis would not be increased by their shares of the bank loan.
Tim’s S corporation basis would be:
Cash contributed: $10,000
Personal loan to LLC: $ 5,000
Total Basis: $15,000
Todd’s S corporation basis would be:
Cash Contributed: $10,000
Total Basis: $10,000
As you can see, if they operated as an S corporation Tim and Todd’s basis would each be $10,000 lower because they do not receive basis for their shares of third party debt.
If they operate as an LLC, each of their basis would be $10,000 higher. This higher basis would allow them to take $10,000 more losses or receive $10,000 tax-free distributions.
Bottom line: if the business will have substantial 3rd party debt and the owners want to recognize losses, the LLC form of business is worth looking at.
If you need help with small business taxes,
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
How LLC Owners Can Avoid Self-Employment Tax
There is a 15.3% tax on self employment income. Self employment income is defined as net income from any trade or business, including partnerships. The IRS treats LLCs as partnerships for tax purposes.
Limited partners are usually not subject to self employment tax because they act merely as investors—they are not involved in the management and daily operations of partnerships.
The issue is whether members of an LLC should be treated as limited partners and should therefore be exempt from self employment tax.
In 1997, the IRS issued proposed regulations that stated that an LLC member is a limited partner (and exempt from self employment tax) unless he:
- has authority to enter into contracts on behalf of the LLC
- participates in the LLC’s business for more than 500 hours during the year
- has personal liability for debts or claims against the LLC by reason of being a member [this is not a problem in Michigan since LLC members have limited liability]
For service partnerships (accounting, legal, architectural, consulting, engineering, etc.), service partners cannot be treated as limited partners unless they only provide de minimis services to the LLC. Naturally de minimis services are not defined.
Based on the first two limitations, most active LLC owners will be subject to self employment tax on their share of the LLC’s profits. There was such an uproar about this that Congress passed a law blocking the proposed regulations and stating that the IRS could not issue regulations defining limited partner until 1998. Neither the IRS nor Congress has acted on this issue since.
Under the proposed regulations (which technically are not binding), there are two ways active LLC members can exclude a portion of their profit from self employment tax.
First: Have More than One Class of Ownership Interest
An LLC can have more than one class of ownership—for example, a general class (management class) and a limited class (investment class). An owner who owns shares in both classes will only pay self employment tax on the profit allocated to the management class.
There are two requirements:
- limited members who are not active in the business own a substantial interest in the limited class. Substantial interest is defined as 20% or more.
- the active business member’s rights and obligations for his limited class is identical to the rights and obligations of the limited members’ limited class interests
Example: Evade LLC is offering one membership unit for $1,000 and 99 investment units for $1,000 each. The one membership unit allows the holder to manage the day to day operations of the LLC. The investment unit holders do not participate in the management or operations of the LLC. Sandy buys the 1 management unit and 49 investment units for $50,000. Other limited members buy the remaining 50 investment units.
The LLC has profit of $100,000. Sandy has 50 units out of 100, so her share of the profits is $50,000. Of this amount, only the $1,000 attributed to her 1% management unit is subject to self employment tax. The remaining profit of $99,000 is allocated to limited members, including Sandy.
In most circumstances, however, the active LLC member will also receive compensation (guaranteed payments) from the LLC, and will be subject to self employment tax on these payments.
Second: LLC Members who Participate More than 500 Hours, but Abstain from Entering into Contracts on Behalf of the LLC
The proposed regulations allow an exemption from self employment tax for individuals holding one class of interest if the individual works more than 500 hours in the LLC, but cannot enter into contracts on behalf of the LLC.
This exemption allows LLCs the flexibility to attract investors with management skill and yet shield them from self employment tax. Note that these LLC members cannot execute contracts on behalf of the LLC.
What’s an LLC Member to Do? Well, There are Five Options
1. Adopt the Proposed Regulations: Follow the above rules defining limited partners and try to meet the exemptions from self employment tax. The benefit of this approach is that following the proposed regulations will shield you from penalty if the IRS challenges your position. The downside is that it is VERY difficult for active LLC members to avoid self employment tax
2. Adopt the Position that All LLC Members are Limited Partners: Basically, claim that all LLC members are exempt from self employment tax. Take this position if you want to be audited!
3. Treat a Portion of Profits as Return on Investment and Exempt from Self Employment Tax: Investment gains are not subject to self employment tax because the gains are the result of investment activity, not business activity. An owner of an LLC can claim that a portion of the profit is merely a return on the capital he invested in the LLC, and is therefore exempt from self employment tax. This is the position the American Bar Association and American Association of CPAs are recommending Congress to adopt.
4. Adopt the Position that Only Reasonable Compensation is Subject to Self Employment Tax: This position is used by S corporation owners to avoid self employment tax. Under this position, LLC members receive guaranteed payments for services they provide to the LLC and pay self employment tax on these guaranteed payments. The LLC members treat the remainder of the LLC profit as being exempt from self employment tax. This is probably the approach adopted by many LLC owners, however there is no authority for this position.
5. Simply Operate Your Business as an S Corporation: The self employment tax rules for S corporations are more established. I have a prior blog post explaining them here. However, the rules for S corporations that provide professional services may be about to change. More about that in a future post.
BONUS STRATEGY: Use an S Corporation to Own LLC Interests
S corporation owners are only subject to self employment tax on their compensation (which must be reasonable). An S corporation can be used to own an LLC interest. When the LLC distributes profit to the S corporation, the shareholder is taxed on the income but is not subject to self employment tax. However, the S corporation should pay a reasonable salary to the shareholder for work performed. Finally, a business purpose should exist for the S corporation owning the LLC interest (tax savings alone is not a valid business purpose).
This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Buzzkill Disclaimer: Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.
