Are “S” Corporations Taxed Differently than Partnership?

Both “S” corporations and partnerships are “pass-thru” entities.  This means that neither an “S” corporation nor a partnership generally pays any federal or state income tax.  Rather the income of an “S” corporation or partnership is calculated and reported at the entity level, but is then “passed-thru” to the owners pro rata based on ownership percentage.  The owners then report the allocated income on their personal income tax returns and pay the associated income tax. 

The allocated income of the owner is subject to income tax whether the owner operates in the form of an “S” corporation or a partnership.  There is however a difference in the way payroll taxes and self-employment taxes are applied to “S” corporations and partnerships.  Partners of a partnership cannot be treated as employees for payroll tax purposes.  Rather, all of a partner’s share of partnership income is treated as earned income and subject to self-employment tax. To the contrary, an owner of an “S” corporation can be treated as an employee and paid a reasonable salary.  The owner's salary is subject to payroll tax (which is taxed at the same rate as self-employment income). But the balance of the business income distributed to the owner will not be treated as “earned income” and will not be subject to payroll or self-employment tax.    

Payroll tax and self-employment tax are comprised of two basic parts.  The first is the social security portion which is imposed at a 12.4% rate on the first $106,800 of wages or self-employment income (“wage base”) for 2011.  The second is the medicare portion which is imposed at a 2.9% rate on all wages and self-employment income without limit.  The key inquiry is what constitutes a “reasonable salary.” 

When using an "S" corporation and setting a salary for the owner(s),  the key inquiry is what constitutes a “reasonable salary.”  This determination can be challenged by the IRS, so the amount of the reasonable salary should be fixed after careful deliberation and consultation with your tax professionals.  If a reasonable salary is set and paid, the owner of an “S” corporation will save at least the 2.9% medicare portion of the payroll tax which would otherwise be paid if the business were operated as a partnership.  

Here’s hoping you find this material helpful.  If you like what you read, please forward this on to a friend. 

If something you read here raises a question, don’t hesitate to email or call at Jsenney@pselaw.com or 937-223-1130.  

AND ONE MORE THING:  Do you know anyone having trouble paying their federal taxes?  The IRS offers an Offer-in-Compromise program.  An offer can be made based on doubt as to liability or doubt as to collectability.  Often the IRS will accept an offer to pay that is substantially less than the full amount owed.  Call me if you want to know more about this program.   Jsenney@pselaw.com or 937-223-1130.  

When is an Owner Personally Liable for Business Obligations?

Even if an owner runs his or her business in the form of a corporation or limited liability company, the owner can be personally liable for certain obligations of the business.  For example, the owner of a corporation or LLC can be held personally liable in the following situations:

(a)        Personal Actions.  An owner can never hide from liabilities created by the owner’s personal acts or omissions.  The liability shield created by the corporation or LLC works only to protect the business owner from obligations of the entity resulting from the actions of employees or other owners.

(b)        Personal Guarantees.  Any personal liability stemming from an owner’s personal guarantee of the debt of an entity is not affected by the existence of the entity.

(c)        Responsible Persons.  If a corporation or LLC fails to pay payroll, sales or similar "trust fund" taxes, any owner who has financial duties or responsibilities with the entity may be found to be a responsible person and liable for a 100% penalty tax.

(d)        Improper Distribution.  Any owner who knowingly receives a distribution from an entity which is contrary to the entity’s organizational documents or state law is liable to the entity and/or other owners for the amount improperly received.

(e)        Contributions.  If the organizational documents of an entity require an owner to make capital contributions, the owners is personally liable to make such contribution.

(f)         Piercing the Corporate Veil.  Under the doctrine of piercing the corporate veil, owners of a corporation or LLC can be liable for entity obligations if the entity is a sham or "alter-ego” for the owners.  Courts are sometimes willing to find owners personally liable for entity obligations where the entity is undercapitalized, the owner pays personal expenses out of the entity’s bank account, or the entity does not follow the required corporate formalities like holding annual meetings and maintaining an up to date corporate record book.

(g)        Participation in Management.  While limited partners of a limited partnership generally enjoy complete liability protection, such liability protection can be lost if the limited partner participates in the management of the limited partnership.   

(h)        Fiduciary Duty.  Ohio case law has imposed a fiduciary obligation on majority owners in their treatment of minority owners.  These cases most often involve promises of continued employment. 

The foregoing is not a complete list of all situations where the owner of a corporation or LLC can be held personally liable for obligations of the entity.  But these situations are relatively common.  To minimize your risk, operate your business as a corporation or LLC, purchase a reasonable level of business insurance, avoid situations which can lead to personal liability and don’t hesitate to consult with your professional advisors.

In future blogs we will be looking at how different types of entities are formed and how different types of entities are taxed for purposes of income, payroll and self-employment taxes.

Here’s hoping you find this material helpful.  If you like what you read, pass the information and the website to a friend.  If something you read here raises a question, don’t hesitate to call.  Jsenney@pselaw.com or 937-223-1130.

AND ONE MORE THING:  The Ohio Department of Taxation has announced that it is going to increase the number of businesses it audits for use tax compliance.  Use tax is similar to sales tax.  Use tax liability often arises when a business purchases taxable goods for its own use from an in-state or out-of-state vendor or over the internet without paying sales tax.  The Ohio Tax Department is offering a voluntary disclosure program which waives penalties and limits a taxpayer's liability to three years of back taxes and interest.  Give me a call if you want to know more about this program.  Jsenney@pselaw.com or 937-223-1130.

Are Owners Personally Liable for Corporation or LLC Obligations?

Under state law, the owners of a corporation or an LLC are generally not liable for the debts and obligations of the entity.  But there are exceptions.  Actually quite a few exceptions.  For example, you can never avoid liability for your own actions.  So if you are driving a car on company business and you run someone over, you are personally liable for the damages.  And it is no defense to say “I was on company business.”  An owner is of course personally liable if he or she signs a personal guarantee for a debt of the corporation or LLC.  But  an owner can be liable as a "responsible party" for state sales taxes, federal and state employee income tax and payroll tax withholding, and other “trust fund” type taxes under state and federal law simply by being an officer or manager.  A more complete list of situations where the owner of a corporation or LLC can be personally liable will be included in a future blog. 

It is still important to run your business in the form of a corporation or LLC.  But it is also important to adequately insure your business against risk.  And even more important to be aware of, and avoid if possible, situations that put your business and personal assets at risk.

Here’s hoping you find this material helpful.  If you like what you read, pass the information and the website to a friend.  If something you read here raises a question, don’t hesitate to call.  Jsenney@pselaw.com or 937-223-1130.

AND ONE MORE THING:  Want to save self-employment/payroll taxes on payments to owners?   Owners of partnerships and most LLCs pay self-employment tax on every dollar.  “S” corporation shareholder-officers don’t.  Give me a call if you want to know why.  Jsenney@pselaw.com or 937-223-1130.

What is the Difference between a Corporation and an LLC?

A corporation is an entity incorporated under state law.  A corporation generally has shareholders, directors and officers.  A corporation is governed in accordance with its Articles of Incorporation, Code of Regulation’s, By-laws and applicable state law.  A limited liability company (“LLC”) is an entity organized under state law.  An LLC is governed in accordance with its Articles of Organization, Operating Agreement, and applicable state law. 

For state law liability purposes, there is very little difference between a corporation and an LLC.  A corporation and an LLC each create a liability shield to protect the owner's personal assets. 

But there can be significant differences in how a corporation and an LLC are treated for tax purposes.   For tax purposes, a corporation is treated as a taxable entity (a “C” corporation which pays tax on its income) unless it makes an "S" election.  If a corporation makes an "S" election, it is treated as a pass-thru entity (an “S corporation”) which “passes-thru” its income to its shareholders (who then report and pay tax on the income).   To the contrary, an LLC can be treated as a  partnership, a “C” corporation, an “S” corporation, a sole proprietorship or other disregarded entity depending on the type and number of owners, and on what if any elections are filed with the IRS.   A more detailed description of the different tax treatment of sole proprietorships, partnerships and corporations will be contained in a future blog.

Here’s hoping you find this material helpful.  If you like what you read, pass the information and the website to a friend.  If something you read here raises a question, don’t hesitate to call. 

AND ONE MORE THING: Did you know that funds are currently available from the federal government to help employers hire and train new employees?  Employers work with the local One-Stop Center to recruit, screen, hire and train the employees.  Funding is limited, so interested employers need to act promptly.   Give me a call if you have questions about this program. 

Why Should My Business be Incorporated?

A lot of small businesses start out as sole proprietorships or partnerships.  But eventually most small businesses take the necessary steps to become a corporation or limited liability company (“LLC”).  Most small business owners choose to operate their business as a corporation or LLC in order to avoid personal liability for debts and obligations of the business.      A sole proprietor or partner is liable for all the debts and obligations of the business even if such liabilities are caused by the actions of an employee or partner.  On the other hand, the owner of a corporation or an LLC is not generally liable for debts or obligations of the business resulting from errors or omissions of employees or other owners.   A more detailed discussion of an owner’s potential personal liability for debts and obligations of a corporation or LLC will be set forth in a future blog.

Here’s hoping you find this material helpful.  If you like what you read, pass the information and the website to a friend.  If something you read here raises a question, don’t hesitate to call. 

AND ONE MORE THING:  It is never to early to start planning for retirement.  Contributions by an employer to a qualified retirement plan are deductible.  A 401(k) plan may also accept employee contributions on a pre-tax basis.  Such employee contributions are not taxed when they go into the plan, but are taxed when they come out.  The law has changed, and a 401(k) plan may now accept Roth IRA contributions.  These Roth contributions are taxed on the way in, but are NOT taxed on the way out.  For a younger business owner or employee this is huge, since it means the appreciation in asset value that occurs over a life time is NEVER taxed.  Also beneficial, is the fact that Roth contributions can be withdrawn in many cases if you need the money without incurring income tax or early distribution penalties.  Give me a call if you would like to talk about setting up a retirement plan suited to you and your business.

Welcome

Hi. My name is Jeff Senney, I am a shareholder of Pickrel, Schaeffer and Ebeling Co., L.P.A. (http://www.pselaw.com/).  I have been working as a tax and business attorney for 25 years.  Over this span, I have helped hundreds (maybe thousands) of owners of small businesses create, grow, operate, manage, finance, acquire, sell, merge, dissolve and transfer their business.  My intention is to share some of the experience and knowledge I've gained in these areas with you. 

I plan on writing a series of short “chapters” that will take the reader thru the various life stages of a small business.  Initially some of the material may seem rather elementary.  That might be because it is simple material.  Or maybe it is because I explain it so well.  You can decide for yourself.  In any event, each chapter will build on the prior chapters, and as the story progresses, I will get deeper into the details of some of the more complex topics.  You can expect to see several new postings each week.

If something you read here raises a question, don’t hesitate to call.  If I can give you some quick clarification, I am happy to help.  If you have an issue or project that requires additional assistance, research, drafting, negotiation, etc, I am also happy to help.  But in that case we’ll need to discuss representation.     

Here’s hoping you find this material helpful.  If you like what you read, please pass the information and the website to a friend. 

AND ONE MORE THING: Have you ever heard of a DISC?  Does your business have significant foreign sales or income?  You can reduce the federal income tax rate on such foreign income to 15%.  Give me a call and ask me how.