KEN KIRSCHENBAUM, ESQ
ALARM - SECURITY INDUSTRY LEGAL EMAIL NEWSLETTER / THE ALARM EXCHANGE
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Comment on tax issues for LLCs and Corps, California and elsewhere
December 10, 2020
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Comment on tax issues for LLCs and Corps, California and elsewhere from November 30, 2020
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Ken,
I am responding to the email that you published from Anon on November 30, 2020 regarding LLC’s and Sub S Corporations.
Anon writes that his company is “currently formed as an LLC.” While LLC’s (Limited Liability Companies) are valid entities, they are considered by the IRS to be “disregarded,” that is, the IRS doesn’t recognize LLC’s (there is no tax form to report LLC income on). Since an LLC is disregarded it must report its income as a recognized entity. In Anon’s case, he appears to be the only member of the LLC. By default, a single member (assuming that the member is a person and not an entity) LLC is considered to be a sole proprietorship (for tax purposes, not legal purposes) by the IRS and must report it’s income on Schedule C if the member’s personal tax return (Form 1040). If there are two or more members, it is considered a partnership and must report on Form 1065 (Partnership Return). If an LLC wants to be treated as a corporation it must file IRS Form 8832, Entity Classification Election (“Check the Box” Election). If it properly files this form, it will be considered a C Corporation by the IRS. Most security companies do not want to be taxed as C Corporations due to the double taxation issues, so an LLC wishing not to be taxed as a C Corporation must also elect S Corporation status by filing Form 2553 Election by a Small Business Corporation, if, it meets the requirements to be taxed as such. Does this seem complicated; it is, so why not just form as an S Corporation in the first place?
Anon is a bit mistaken about the nature of profits and income of an LLC or S Corporation. Neither S Corporations nor LLC’s (except for LLC’s that elect to be taxed as C Corporations) pay tax at the Federal level. Their income flows through to the members or shareholders on Form K-1 and is reported on their personal tax returns. “Leaving $20,000 in the business for growth” doesn’t avoid the taxes, Anon would end up paying tax on his salary, and on the residual $20,000 of income whether he “leaves it in the business” or distributes it. Anon is confusing these entities with C Corporations which do pay tax on their income and often pay out their expected earnings to their shareholders as bonuses to avoid the double taxation. Anon’s question was “what corp can pay me a salary so I get taxed on 100K if that is my salary and the 20K profit can stay with corp and still get taxed but stay with the corp instead of pass through to me as an individual?” The answer would be a C Corporation but it is not that simple. Yes the $20k profit would “stay with the corp and still get taxed” but it would be taxed at the corporate level (21%) and, taxed again as a dividend when Anon took a distribution or sold the company. Additionally, if Anon ever sells the RMR of the C Corporation in an asset sale (the preferred manner in the security industry) he would be taxed twice, once at the corporate level, and once at the personal level (as a dividend). Yes the $20,000 would be taxed to Anon in an S Corporation but he could then leave it in the business or withdraw it, with no additional tax in most cases.
Another issue that Anon has is that LLC’s that are taxed as sole proprietorships or partnerships cannot pay salaries to their member(s). The member(s) must report their entire share of the LLC’s income on their personal returns, and, it gets worse, if they are actively involved in the business (as Anon most assuredly is) they must pay self-employment tax (15.3%) on the entire amount (up to $143,909 in 2019). And, it gets worse, they also cannot withhold taxes so they must make quarterly estimated tax payments. But wait, it gets worse, the State of California also tacks on an additional tax for LLCs, of between $800 and $12,590 depending on their total income. California taxes C Corporations at 8.84%, but only taxes Sub S Corps at 1.5%, another reason not to be a C Corp in California.
Subchapter S Corporations don’t have these issues; a Sub S corporation is required to pay its shareholders who are active in the business a “reasonable salary” and can allow the shareholder’s share of the income to “pass through” to the shareholder without being subject to FICA and Medicare taxes. Additionally, income from pass through entities is only taxable (with certain limitations) at 80% of the amount. This means that Sub S Shareholders get a 20% deduction on their residual income.
If this is confusing it is because it is. As Ken points out, operating as an S Corporation is typically the best entity choice for a security company. The best strategy is to retain a tax advisor who knows the rules and who knows the industry to properly advise you.
We are currently having phone conferences with over 100 of our clients to help them strategize the best blend of salary, pass through income, capital expenditures, and other decisions, now, not in March of 2021 when it is too late. This is also something that business owners shouldn’t DIY. Just as the owner of a jewelry store shouldn’t run down to Costco and pick up a DIY alarm system, owners of a business of any substance should retain skilled, knowledgeable, legal and tax practitioners who can give them advice which is not only accurate, but that makes economic sense.
Mitch Reitman
Reitman Consulting Group
Fort Worth, TX
817-698-9999
http://www.reitman.us
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Response
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File that under “more than you want to know”. Also, its way more than you need to know, because all you need to know is Mitch’s phone number; then you need to call it. I don’t know any accountants who have Mitch’s knowledge of accounting and taxes applicable to the alarm industry.
As far as all those California LLCs, time to get rid of them and form a Subchapter S corporation. More than one shareholder? Then we also need to do a shareholder’s agreement so we know what happens when one shareholder wants to sell, retires, gets sick or dies. Why should you bother to take this action now? Because you don’t want to wait until you have to or it’s too late. Penny wise, dollar foolish; an ounce of prevention is worth a pound of cure.
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Ken Kirschenbaum,Esq
Kirschenbaum & Kirschenbaum PC
Attorneys at Law
200 Garden City Plaza
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516 747 6700 x 301
ken@kirschenbaumesq.com
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