Do I have to be taxed as an SCorp?

Question

Hi All,

My CPA is advising that I have my LLC be taxed as an SCorp because I'm an active participant in my fix and flips.  To clarify, I have a multiple member LLC (me and my husband).  In that LLC, I make some private money loans, do some fix and flip work and, in the near future, will have some rental income.  In 2014 we'll likely have a 25/75 split between passive (interest income) and 'investment' (fix & flip income).  In future years, that will likely become more a 50/50 split.

I disagree with my accountant and think that I should be able to pass all that income through on a K1 (or schedule C) and NOT have to pay myself a "market salary" and then take dividends in an S Corp.

Can any expert out there chime in on whether this S Corp election is likely to be required?

Thank you!

Danielle

Jake Hottenrott · Answer

Danielle,

I think I can help you understand the logic behind your CPA's suggestion.  It is surely not a "requirement" to have it taxed as an S Corp.  Without knowing your situation or goals, I can't tell you what is best for you.  If your CPA didn't explain the logic behind his suggestion, then you may want to find an adviser who you can work with to understand not only the output, but the decisions and information that were taken into account to get to the end.

Being classified as an S corporation employee has one potential big advantage: S corporation tax treatment can provide a way to take some money out of your business without paying employment taxes. This is because you do not have to pay employment tax on distributions (dividends) from your S corporation—that is, on earnings and profits that pass through the corporation to you as an owner, not as an employee in compensation for your services. The larger your distribution, the less employment tax you’ll pay. The S corporation is the only business form that makes it possible for its owners to save on Social Security and Medicare taxes. This is the main reason S corporations have been, and remain, popular with professionals.

Example: Mel forms an LLC to operate his accounting practice and elects to have it taxed as an S Corporation. Mel is an employee of the LLC and receives a $100,000 salary. The remaining $100,000 of the business's profits are passed through the S corporation and reported as an S corporation distribution on Mel’s personal income tax return, not as employee salary. Because it is not viewed as employee wages, neither Mel nor his corporation need to pay Social Security or Medicare tax on this amount. Mel and his corporation only pay a total of $15,300 in employment taxes (15.3% x $100,000 = $15,300). Had Mel not elected S corporation status for his LLC, he would have had to pay self-employment tax on his entire $200,000 profit. This would have required him to pay an additional $2,900 in Medicare taxes and $1,252 in Social Security taxes.

I hope this helps!  If you have any additional questions, feel free to keep the ball rolling here!

Thanks,

Jake

Steven Hamilton II · Answer

Danielle,

You are required to pay yourself a salary if you are taking money out of the business other than paying back amounts you have loaned.

Even if you are a partnership you still have to allocate funds to wage like payments called "Guaranteed Payments" Those are subject to SE Tax.  You may be a better candidate for multiple entities. Or a structured partnership.A common statement said is flip in a corporation and rentals in a partnership. You CAN do both in a partnership if done correctly.You need to find an accountant who also invests heavily in real estate.

One tip.  NEVER EVER hold rentals in a corporation. That goes for S or C-corps.

Brandon Hall · Answer

Hi Danielle,

Yes that is correct, sorry to cause confusion. A C-Corp generates accumulated earnings and profits. An S corporation is not permitted to generate more than 25 percent of its gross receipts from passive income in any given year if it has accumulated earnings and profits. So if your S-Corp has never been a C-Corp, you will be fine in that regard.

One other thing I'd like to mention - in an S-Corp, you may only deduct losses to the extent of your basis in the S-Corp. Specifically, losses are limited first by your shareholder basis, next by the at-risk requirements, and finally by the passive activity limits. In theory, if you are taking large losses for tax purposes on your rentals, you may not be able to deduct them in full. Instead you would be carrying the losses over into future years.

Not legal advice.

**Edit: Here is a good article explaining it -http://hbsbusiness.com/index.php/site/articles/s-corporations_loss-deduction_danger/

Danielle D. · Answer

Thank you all for your advice.  It's crazy how much conflicting information is out there.  To Brandon's answer to C. regarding 25% passive income...  I spoke to a CPA yesterday who said that the rule only applies to companies who used to be C Corps and switched to S Corp status.  For those who start as S Corps or LLCs, the rule doesn't apply.  I've heard that twice now.

Brandon Hall · Answer

A. Yes you are correct. S-Corps are there to protect your distributions from the employment tax. Only your wages will be subject to employment tax. So take a market wage, then pay yourself distributions on top of that.

B. Correct.

C. The reason that Steven suggested flips in an S-Corp and passive rental income in an LLC is that an S-Corp has passive activity requirements (passive activities cannot be greater than 25% of gross income). An S-Corp will provide you with limited liability (only liable for what you put into the S-Corp) as long as you do not "pierce the corporate veil" which basically means don't co-mingle personal expenses with your S-Corp funds.

Steven Hamilton II · Answer

Danielle,You only have to pay wages if distributions are being taken from the corp.  If money comes out, wages must be paid.

That is not true, A S-corp acn be just fine, you must simply follow the rules. AN LLC is irrelevant for tax purposes. It can be taxed as any type of entity.

I don't have any suggestions for anyone out that direction Sorry.  Don't feel like you need someone local.  Many of us accountants work with people worldwide.

Danielle D. · Answer

Hi All,

Thank you for your responses.  If I understand what you are all saying then:

A.  The income I earn from flipping homes can't simply be passed through and then subject only to my income tax.  At least part of it has to be paid to me as W2 wages and subject to withholding.  If I don't opt to be taxed as an SCorp then I will pay the employee and employer portion of withholding on ALL of the income.  If I do opt for SCorp status, I can shield my distributions from the employer withholding.

B.  Passive income is always a pass through - no SE taxes paid.

C.  Steven, you suggested flips in an SCorp but my understanding is that the SCorp doesn't offer the legal protection that an LLC does.  Are you saying flips in an LLC that's taxed as an S Corp?

Finally, can anyone recommend a great real estate CPA in Denver?

Thanks again!

Danielle

Wayne Brooks · Answer

There's no double dipping with the S corp.  the reason for havi g the S corp, is so the scorp can pay you a "reasonable" salary, subject to withholding, then the rest as "profit" not subject to withholding.  Without the Scorp all passed thru flip income is subject to withholding.  The passive interest income won't be affected.

@Steven Hamilton II can clarify if I'm off base.

Hattie Dizmond · Answer

I'm confused.  Taxing an LLC as an S-Corp is done as a tax mitigation strategy, because he avoid the double dip of straight C-Corp taxes.  However, your LLC can still pay you a market salary for your work.

Do I have to be taxed as an SCorp?

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