Service owned business: Examine with and without a partner

2. If you answered, yes, to number 3, and you have a partner then the LLC or S corporation is a possibility.

3. If you have no partner and a service business then the S corporation is usually going to be the best choice of entity.*

*an LLC taxed as a sole proprietorship is a possibility, later we will address the limitation of a single member LLC. For our purposes, our discussion will mostly center on the LLC taxed as a partnership, which means it must have two partners. Many times someone can bring someone in the entity as a 2-5% partner to be bring the LLC back into play as a partnership. If you are an S corporation you must meet the requirements for a stockholder. (a foreigner with a service business can only be a C corporation or LLC. If a C corporation they must eliminate all profit, if an LLC, then if they are the member they will have to pay 39.6% tax on all distributions and if they are a corporation they will have to pay 35% tax on distributions.

4. Assuming you have a partner in your business and you sell a service: (you still need to address selling a product with or without a partner and comparing the S corporation and LLC and C corp).

5. look at your answer on number 5 , how much earned income do you currently earn:

The key factor is, are you currently earning $84,900 a year? That is the 2002 SE tax limit that you pay up to 15.3% . Above this level you pay 2.9%. This is important because an S corporation can move income into that which is not subject to SE taxes. With an LLC, typically the members are actively involved in the business and therefore they are going to receive all distributions subject to SE taxes. If you and your partner are already about the $84,900 level, then the SE tax saving strategy of an S corporation is not an important factor. The potential savings of 2.9% then becomes a less important factor (unless the entity has high net profits in the S corporation and you live in a state that has a high state tax on S corporations. California charges 1.5% on net profits.

Example: The taxable income generated by your S corporation business is estimated to be $100,000 for 2002 before you pay yourself. You take a $50,000 salary. Only that amount is hit with the 15.3 percent federal social security and Medicare tax, which amounts to $7,650. You can withdraw the remaining corporate cash flow in the form of distributions to yourself that will not be subject to SE taxes (this will be added to your personal income on which you will pay tax at your current tax bracket).

If you operate the same business as an LLC where each member is subject to SE taxes, you owe SE tax on your entire $100,000 profit, for a total of $13,427.60 (15.3 percent of the first $84,940 and 2.9 percent of the remaining $15,100). Operating as an S corporation could save you thousands ($13,427.60-$7,650= $5,777.60).

Remember: You must be able to show that a $50,000 salary is reasonable. If the IRS thinks it’s too low, it may try to reclassify all or part of your purported cash distributions as disguised wages.

6. If the partners currently earn over $84,900, then the SE tax savings will really not affect your outcome, only the 2.9% comes into play. Next, it is important to determine the difference between the LLC and S corporation for a service business with a partner.

7. Do both partners meet the S corporation requirements for a shareholder? They are;

The corporation may have as shareholders only individuals, estates or certain trusts. Partnership and corporations can not be shareholders.
Only citizens of the United States can be shareholders or resident aliens.
The corporation can only have one class of stock.
The corporation can not have more than 75 shareholders.

If the partners can not meet these tests, then a service business with a partner will more than likely use an LLC as taxed as a partnership as the best choice of entity.

8. Let’s assume the partners meet these tests. Next, how will the business be financed? If the new business will require financing from outside sources like a bank, the LLC may be preferable. The outside financing if non-recourse (they do not have to give a personal guarantee) will add to the basis of the owners shares if taxed as a partnership (an LLC). This will allow them to take more money tax free from the entity. If an S corporation in this situation you would not get the same stepped up basis. If the owners provided the financing, then the basis would be the same in the LLC or S corporation. If the debt is recourse(requiring a personal guarantee) then this will not add to the basis of the members of an LLC, therefore we would still consider both an LLC and S corporation. The key question is what bank would loan a new LLC money as non-recourse debt? Typically is there is a piece of property being purchased by the new entity, the bank would provide the loan based upon the piece of property. If the loan was just for operating capital, that would typically be recourse and add nothing to the basis. Probably the common situation would be a loan against buying an office building or perhaps equipment. It is recommended to check with your CPA and attorney on this subject.

Conclusion, if there is non-recourse financing an LLC would be the best choice for a service orientated business with a partner. Especially if both partners already earned above $84,900 in 2002.

9. Does the business expect to incur a net loss? Many business ventures suffer losses in the first few years due to heavy start-up costs, front-loaded tax depreciation, and overhead in excess of revue. Losses would flow through to the personal tax return of the partners in either an S corporation or LLC. Losses can be written up to the extent of your basis in your LLC interest or S corporation stock. As we already mentioned, if the LLC has non-recourse debt, the LLC members will have more tax basis (against which losses can be used) in their LLC interest than S corporation shareholders will have in their basis in their stock, because LLC members can include their share of the LLC debt in their basis. An S corporation does not receive any benefit due to the S corporation’s debt, unless the debt is owed by the S corporation to that shareholder.

Result, if a service business with partners, expected to have losses, advantage to the LLC.

10. Will the service business expect to accumulate assets within the business as it grows, or a net worth because a client base is developed that pays renewal fees…? If this is the case you want to protect the personal ownership of the company. If you have your service business as an S corporation and one of the owners get sued personally and their insurance policy does not cover it, then the creditor may get control of their most valuable asset, stock in your business. Now, you have a new partner! If you have an LLC, the charging order protection is applied**

Result, if the business is expected to grow in net worth, the LLC is the best choice for a service business with a partner.

** charging order: There are two things that could happen if an LLC is attacked. One is what happens when the LLC itself is attacked, the other is when the owners of the LLC are attacked. If a judgment is awarded against LLC itself, it may be levied, and LLC’s assets liquidated in payment (this would work the same way for a corporation). The real advantage, that makes an LLC taxed as a partnership better than a C corporation or S corporation is, if the member of the LLC is levied, distributions usually cannot be used to satisfy a member’s judgment debt. Creditors have to obtain a ‘Charging Order’. This gives them the rights to any distributions made by the LLC to that particular member, which means the creditor receives an economic interest.

The creditor may get something they didn't intend on receiving, a huge tax bill. Here is how that can happen: Since an assignment of the rights of income under a charging order may also mean an assignment of the liability for taxes, the creditor may be given a K-1 reflecting the taxable income allocated to the K-1. He or she may have to pay the taxes whether any distribution are made by the LLC or not! This may cause uneasiness from the pursuing attorney in many cases. In the real world, this becomes negotiating power.

In review, the main time an S corporation will be the best choice of an entity with a service business with a partner, is when;

Both partners are well below the SE level of $80,400 in earned income.
There is no financing being down the S corporation that is non-recourse.
Losses are expected to be minimal, or if not, that if any financing it is done by the shareholder.
There is really no major net worth being accumulated by the business.
You and your partner meet all the S corporation requirements.

We feel the first step in your new business is a critical one. Which entity is best for you? Please call us at (888) 466-7566, and ask for a free consultation with a Senior Consultant.

Service Owned Business: Examine with and without a partner

Service Owned Business: Examine
with and without a partner