The Laurex Process: Strategy Development
LLC vs. S-Corporation
By Thomas Fafinski

While Limited Liability Companies (“L.L.C.”) are in particular vogue, it is still appropriate to consider using an S-Corporation in conjunction with an L.L.C. This strategy allows you to acquire or manage your own real estate and maximize the limited liability benefits with more favorable tax treatment. This strategy has really rendered the use of a sole proprietorship or general partnership to the inexperienced.

An S-corporation and an LLC are formed in very similar ways. In fact, the rules governing LLC’s mirror Chapter 302A of the Minnesota Statutes, making the governing of LLCs virtually identical to that of S-Corporations. Each have documents which allow for their creation (Articles of Organization and Articles of Incorporation) as well as rules which govern the entity operation (By-Laws). While the LLC has a governing body, referred to as the Board of Governors, the S-Corporations have the Board of Directors. Another similar issue of concern involves ownership by multiple parties, i.e. multiple shareholders or members. In either an LLC or a corporation, the parties should enter into a Buy/Sell Agreement to govern their rights upon the happening of certain triggers (Sales to Third Party, Death, Disability).

While the entity forms are very similar in Minnesota, the differences are important. For instance, an S-Corporation cannot be owned by more than 75 shareholders, while an LLC can have an unlimited number of members. An S-Corporation can only have one class of stock, while an LLC is able to have a myriad of possibilities with respect to the division of control and profits. An S-Corp cannot be owned by a non-resident alien whereas an LLC may be owned by any person.

Perhaps the two most significant differences, though, involve tax treatment. When an LLC is capitalized with an asset, that asset can be distributed to it’s members incurring taxable consequences. For example, if two partners decide to form an LLC and become the only members of the LLC, then subsequently purchase 2 properties, the parties could distribute one property to one member and the other property to the other member without incurring any tax consequences. This is true if the distribution occurs 10 years after it’s acquisition.

The opposite occurs with an S-Corporation. When the same assets that were used to capitalize a corporation are divided between the owners, that would normally give rise to a taxable event to each shareholder receiving a distribution. The impact can be profound in that the shareholder is taxed as though there were a sale from the corporation at fair market value. In other words, years of appreciation within the respective properties would be subject to taxation. While there are a unique set of rules which allow a corporation, in limited circumstances, to be treated in the same way as the LLC, the entire issue can be avoided by using the LLC form of ownership for any asset which is appreciating in nature.

Perhaps the most important feature of an S-Corporation, which allows it to continue to strive, is the ability to distinguish between wage earning income (which is subject to withholding tax) and income which is derived as a return on investment. Any person who is self employed, or employed by an entity in which he or she is the owner, is subject to wage withholding tax (as is any employee). As the employer too, this business owner is also paying the employer’s portion of the withholding tax by virtue of their ownership in the entity. This amounts to a penalty of approximately 18% for all income that is considered wage earning. S-Corporations are the only method of ownership which allows you to make a distinction between what you earn as an employee and what you earned as a return on your investment. With respect to C-Corporations, the return on investment money is subject to double taxation, which is roughly equivalent to the wage withholding tax penalty. The wage earning services that you are performing on behalf of your corporation are easy to quantify. You can bypass the double taxation if you qualify to be an owner of an S Corporation by industry standards (i.e. reasonable wage for a liquor store owner is $30,000 by salary survey, reasonable compensation for a manager of rental real estate is 5% of gross revenues). You are entitled to a return on your investment and, by making this destruction with your income as an owner of an S Corporation, you can avoid paying withholding tax on the non-wage earning portion.

There is, however, a method of recognizing the beneficial attributes of an LLC and an S-Crop when it comes to business of investing in managing real estate. By holding the asset in an LLC, you protect your appreciation from potential taxation. By managing the asset pursuant to a management agreement through an S-Corp, you are able to make distinctions between income which is a return on investment. There are guidelines that you should consider to prevent abuse of this, strategy, and reduce the risk of inquiry by governing authorities.

Link to Entity Selection Table

Article Provided by:

Thomas Fafinski
BenePartum Law Group