Many sales representative organizations, like other businesses, are structured as limited liability companies (“LLCs”). The preponderance of LLCs with more than one member are treated as partnerships for tax purposes. Some multi-member LLCs elect to be treated as corporations and in such case, many elect S corporation status. Similarly, most LLCs with only one member are disregarded entities and treated as sole proprietorships for tax purposes although the same election to be treated as corporations is available. LLC formation is relatively straightforward and, particularly for those LLCs without employees, income tax reporting is relatively uncomplicated.
As many sales representative organizations begin generating larger amounts of income, LLC members or owners contemplate converting their organizations to S corporations. One of the common motivations is the payroll tax savings that can be achieved through an S corporation structure. This of course begs the question as to what is involved in the conversion of an LLC to a corporation and how the payroll tax savings can be achieved.
LLCs, like S corporations, are pass-thru entities meaning all of the company profits, losses, gains and other items, while reflected on the entity tax returns, are taken into account in computing the income of the members. In addition to being subject to income taxes, a member actively involved in the LLC’s business must treat the entire member’s share of LLC earnings as self-employment income on the member’s personal income tax returns. This subjects the member’s income to payroll taxes largely consisting of social security taxes (e.g. FICA taxes) and Medicare taxes. While FICA taxes phase out after a certain threshold amount of income is earned, there is no cap on the Medicare tax imposed on self-employment income.
More specifically, in 2021, the first $142,800 of the income of an LLC member active in the business will be subject to FICA tax. As self-employed individuals for tax reporting purposes, each LLC member must pay the full amount of the FICA tax obligation. This differs from the employment setting where this obligation is equally shared by employers and employees. Moreover, a member’s entire share of LLC earnings is subject to the 2.9% Medicare tax and this must all be paid by the member. In the employment context, the Medicare tax obligation, like the FICA tax obligation, is equally shared between employers and employees.
In the S corporation structure, wages paid, whether to an employee or an owner/employee who receives compensation for services rendered, are subject to payroll taxes, half of which is paid by the employer and half of which is paid by the employee. As with LLCs, the same threshold phaseout applies to FICA taxes while there is no threshold for Medicare taxes.
The key difference is that distributions of profits and other items from S corporations which are not paid in the form of salary are not considered earned income for tax purposes and are not subject to employment taxes. This creates an incentive for S corporation shareholders to reduce their salaries and receive S corporation distributions free of payroll taxes.
The obvious question is how much of the S corporation’s earnings can be reported as salary and how much can be reported as distributions, the motivation being to maximize the amount which can be reported as distributions. There is no bright-line test which S corporation owners can rely upon. The IRS has challenged S corporation owners who receive unreasonably low salaries in the hope of significantly reducing payroll taxes. With undefined rules, of course, not all tax practitioners agree. In the absence of specific guidance and increasing IRS scrutiny, S corporation owners should strive to be reasonable in determining their salaries.
As S corporation shareholders seek to minimize their salaries, the collateral consequences of doing so should be considered. Company contributions to profit sharing and pension plans, for example, are based on the amount of salary reported so that an owner whose salary decreases may also receive a smaller share of company-paid retirement plan contributions. Similar consequences can apply with company-sponsored group life insurance where coverage is based on salaries paid. For those S corporation shareholders who routinely receive salaries below the FICA wage base, lower salaries may ultimately result in lower social security benefits. The prospective loss of these benefits, if any, must be weighed against the potential payroll tax savings.
Once a decision is made to convert to S corporation status, the manner of conversion is relatively easy. An LLC simply files an election to be treated as a corporation and taxed as an S corporation. Assuming all of the statutory requirements are satisfied, the LLC becomes an S corporation upon making the election. The election can be made as of a current or prospective date. An election can also be made retroactively on or before the fifteenth day of the third month following the effective date of the election.
Prior to the effective date of the S corporation election, the LLC must report its income consistently with past filings. If there are more than one LLC members, the income and other tax items for the pre-election period must be reported on a partnership income tax return and if there is only one LLC member, then income and other tax items must be reported as a sole proprietorship. From and after the effective date of the election, the company’s income is reported on a corporate income tax return but allocated to the shareholders who report the income based on their pro rata ownership of company stock.
With some exceptions, S corporations are required to utilize a calendar year for income tax reporting purposes. That being said, an S corporation election can still be made at any time during the year. If the election takes effect mid-year, the corporation will file a short period income tax return for the period beginning on the date of the election and ending on December 31. Returns for subsequent years will be filed for each full twelve-month calendar year that the corporation remains in existence.
Other factors need to be considered in effectuating a conversion. The stringent requirements of S corporation ownership must be satisfied as S corporations cannot have nonresident aliens, most types of corporations, many types of trusts and certain other persons and entities as shareholders. Businesses previously operating as LLCs should have their governing documents updated so that they are consistent with S corporation status. LLC operating agreements, for example, almost always contain provisions that incorporate partnership tax provisions which are inconsistent with S corporation requirements. These agreements should be amended effective as of the date of the election to remove the provisions inconsistent with S corporation status. Because the IRS could look closely at S corporation governing documents, the failure to amend these documents to comply with S corporation rules could jeopardize the company’s S corporation status.
With LLCs that have more than one member, there are sometimes different arrangements as to the manner in which owners share in profits and losses and cash distributions. S corporation rules require that income be reported by the shareholders proportionately based on stock ownership. If an LLC operating agreement permits disproportionate allocations of income, loss, distributions and other items, those provisions must be modified. To the extent S corporation owners wish to share income in a disproportionate manner, they can pay differing salaries to the owners to accomplish that objective; distributions must nevertheless be proportionate.
LLCs often require owners to maintain separate capital accounts. If these capital accounts are not proportionate to the ownership of the S corporation, the LLC might consider eliminating the disproportionate capital account balances, whether by special allocations of income or otherwise, prior to the effective date of the S corporation election as it may not be possible to do so once S corporation status takes effect.
Changing times and circumstances may cause business owners to rethink their business structure. For the LLC seeking to become an S corporation, the seemingly simple means of conversion should only be undertaken after all of the consequences are properly considered.
Please contact Bruce Bell with any questions at (312) 648-2300 or e-mail at bruce.bell@sfbbg.com.