\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0In today's high-tax environment, practitioners should explore having active member(s) in an LLC make the 5 corporation tax election.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Practitioners have felt comfortable advising clients to choose the limited liability company (LLC) because of its ease of organization, flexibility elimination of annual reporting requirements and relative lack of corporate formalities. Moreover, because default income tax classification rules treat the LLC as a "pass-through" entity (i.e., one not taxed at the entity level as a partnership or disregarded entity) and require no independent tax election, most practitioners believed that failing to evaluate other tax elections was irrelevant and without material consequence. While the belief that the LLC's default partnership or disregarded entity tax treatment is ideal from an income tax perspective is certainly true in most instances, entirely ignored in this analysis is the employment tax regime.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Until recently, practitioners paid little attention to the fact that another type of "pass-through" tax election could be made for the LLC: the Subchapter S corporation (S corporation). While "pass-through" for income tax purposes, the S corporation is also treated favorably from a self-employment tax perspective under current tax law, unlike partnership or disregarded entity tax classifications. The distinction is critical, as the Affordable Care Act a/k/a "Obamacare" raised self-employment taxes. By considering having the LLC make a Subchapter S election with the Internal Revenue Service for members who are active owners in the LLC, significant self-employment tax savings may be recognized while maintaining many advantages a LLC entity provides. Potentially, these savings may also largely offset the increased income taxes under the American Taxpayer Relief Act.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Because of its many benefits, the LLC is easily the entity of choice in South Carolina. According to data made available to the authors from the S.C. Secretary of State, LLCs comprised well over 90 percent of 2013's major entity formations. The 24,451 domestic LLCs formed last year represented an amazing increase of 21.5 percent from just two years earlier; by comparison, the 1,961 corporations incorporated in 2013 represented a 11.5 percent decline from 2011. Only 207 limited partnerships were established in the most recent year. Considering that South Carolina adopted the Uniform Limited Liability Company Act (ULLCA) less than 20 years ago (in 1996), this reliance on LLCs is even more astounding.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0The preference of practitioners and clients (who do not need to hire an attorney to file the Articles of Organization) for LLCs has been assisted by the Internal Revenue Service (IRS), whose default rules treat LLCs as pass-through entities for income tax purposes. Around the same time as the passage of the South Carolina ULLCA, the IRS and the U.S. Treasury Department announced in Notice 95-14 a proposal to simplify the classification regulations to allow taxpayers to treat unincorporated business organizations as partnerships or as corporations on an elective basis. Effective January 1,1997, they finalized what are now called the "Check-the-Box" Regulations.1 Under these new regulations, any business entity, such as an LLC, that is not required to be treated as a corporation for federal tax purposes may choose its classification under these regulations. Absent an affirmative election via the IRS Form 8832 Entity Classification Election to be taxed as a corporation, an LLC, by the default rules, will be taxed as a partnership if it has at least two members or as a disregarded entity separate from its owner if it has just a single member.2 Partnership tax or disregarded entity treatment both confer "pass-through" income tax status on the LLC.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0What is self-employment tax?
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Self-employment tax is a tax consisting of Social Security taxes and Medicare surtaxes primarily for taxpayers who work for themselves. For 2014, the first $117,000 of a taxpayer's combined wages and net earnings are subject to the Social Security tax of 12.4 percent. Additionally, all of a taxpayer's combined wages and net earnings in the current year are subject to the 2.9 percent Medicare surtax. Under the Affordable Care Act (ACA), an additional Medicare surtax rate of 0.9 percent (for a total of 3.8 percent) went into effect and applies to wages and earned income above the threshold amount (discussed below).
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0The ACA and ATRA
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Two major pieces of federal tax legislation became effective in 2013, leading many tax experts to believe that S corporations will now emerge as the preferred entity for closely held businesses.3 After passage of the ACA, the IRS itself projected that the S corporation would go from a plurality of tax elections presently to a substantial majority by 2019.4 To understand why the S corporation is becoming the preferred tax entity for certain taxpayers in light of recent tax legislation, a very brief analysis of both recent tax laws is necessary.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0First, effective January 1, 2013, the ACA increased the Medicare surtax on "earned" income (i.e., self-employment related income) to 3.8 percent for certain income earners. Specifically, the ACA, as amended by Section 1402(b)(1)(B) of the Health Care and Education Reconciliation Act of 2010, amend-ed Section 3101(b) of the Internal Revenue Code to impose an additional 0.9 percent Medicare surtax on the earned income of high-income taxpayers above certain thresholds. For single taxpayers, the threshold is modified adjusted gross income of $200,000 per year and for married taxpayers, $250,000 (for those that file separately, it is $125,000).
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Moreover, there is no limit on the amount or compensation or self-employment income subject to the new Medicare surtax. Perhaps most importantly from a tax planning perspective, the threshold amounts are not indexed for inflation, which means more taxpayers will be affected by this new tax in future years.5
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Second, on the same day as the ACA, the inaptly named American Taxpayer Relief Act of 2012 (ATRA), also became effective. ATRA increased the maximum marginal individual income tax rate from 35 percent to 39.6 percent for individual taxpayers having taxable income over $400,000 ($406,750 in 2014) and for married couples filing jointly having taxable income over $450,000 ($457,600 in 2014).6 For those filing separately, the highest income tax bracket begins at $228,800.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0More important to a larger pool of taxpayers, ATRA imposed a number of "stealth" tax increases for taxpayers at lower income levels. The effective tax rates of individual taxpayers having threshold adjusted gross income of $250,000 and couples with $300,000 were increased as a result of the reinstatement of the phase-outs on itemized deductions and personal exemptions. As to phase-outs, ATRA reinstated the "Pease" limitation on itemized deductions, so the affected taxpayers above must reduce their itemized deductions by three percent of the amount by which the taxpayer's income exceeds the threshold amounts above (subject to some limitations). As to personal exemptions, the total exemptions of a taxpayer are reduced by two percent for each $2,500 by which that taxpayer's income exceeds the thresholds above.7
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Together, the ACA and ATRA imposed significant new tax increases on many self-employed taxpayers. The most affected self-employed taxpayers not only saw their itemized deductions and exemptions phased out, but their total nominal tax rates increase by up to 8.6 percent (3.8 percent under the ACA and 4.6 percent under ATRA).
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0A self-employed taxpayer active in her LLC's business, however, has a major tool at her disposal to mitigate her overall tax burden: electing S corporation status.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Members of LLCs with partnership or disregarded tax entity treatment are subject to self-employment taxes on all pass-through partnership income distributions.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0As a general rule, self-employment income includes a partner's entire distributive share of pass-through income from a partner-ship, however characterized that income may be.8 While there is a narrow exception to this rule for a "limited partner," it is inapplicable to LLC members who participate in the LLC's business more than 500 hours in a year.9
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Therefore, because a partner's entire distributive share of the partnership's (or disregarded entity's, as the case may be) income is subject to self-employment tax, an unmarried LLC member filing his return as single is subject to 12.4 percent Social Security tax on income up to $117,000, 2.9 percent Medicare surtax on income up to $200,000 ($250,000 if the member is married and files jointly), and then 3.8 percent ACA Medicare surtax on income thereafter.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0"Materially participating" members of LLCs with S corporation treatment may avoid self-employment taxes on all pass-through S corporation income distributions.
\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Conversely to partnership and disregarded entity tax treatment, the IRS has long held that an S corporation shareholder's distributive share of the...