Wealth Planning News

Vol. VI, No. 3

S Corporations vs. Partnerships

 

S corporations are entities that would be taxed as a normal corporation had the shareholders not made a timely election to be taxed as a special type of pass through entity.

Partnerships are pass-through entities from which all net profits are taxed to the partners on their personal tax returns, and from which partners are not given any personal protection of the partners' other personal assets for claims arising out of the partnership operations.

When Are S Corporations Normally Used?

 

S corporations can protect shareholders from personal liability on any large claims arising out of the entities' business operations. So a shareholder is getting a degree of asset protection for other personal assets of the shareholder.

S corporations are normally used where the owners want to avoid having all profits treated as earned income of the owner and therefore subject to self-employment and Medicare taxes, which can result in a large tax bill. An S corporation can pay an owner a reasonable salary, which is of course subject to self-employment and Medicare taxes. But net income remaining after such salary may then be distributed to the shareholder as a dividend not subject to any self-employment or Medicare tax.

Farmer Holding Goat

So Why Are S Corporations Not Used For Most Business Entities? 

Other entities can be designed to shield owners from personal liability for claims arising out of business operations of the entity, or from what is called vicarious liability arising out of property owned by the entity. A limited liability company owning an investment property such as a rental house or a commercial building will allow the LLC owners to avoid personal liability if the property gives rise to a claim for damages to a tenant, since such an "inside claim" stops at the wall of the LLC, meaning the property owned by the LLC may be taken by a claimant but the other assets of the LLC owners are not subject to loss.

 

But an LLC is normally taxed as a partnership, meaning all of its net income that passes through to its owners is subject to self-employment and Medicare taxes, which can turn out to be a huge disadvantage when compared to a corporation.

 

The most significant disadvantage of a corporation, even an S corporation, is loss of flexibility if an owner wants to ever remove an asset from the corporation for estate or business planning. Such a transfer of an asset from the corporation to its owner is deemed by the IRS as a sale by the entity of the asset to the shareholder. This tax issue can result in taxes owed by the shareholder on the difference between the cost basis of the asset and its actual fair market value. Since the asset has not really been sold to anyone, this tax is one on what may be thought of as phantom income of a shareholder who has no actual sales proceeds on hand with which to pay such tax.

 

To avoid this tax disadvantage most thoughtful planners and accountants have decided it is best to provide for flexibility to owners by never using a corporation, even a S corporation, for ownership of any asset likely to appreciate in value. Such assets include investment real estate. Indeed, many tax professional advisors consider it malpractice by an attorney or accountant who advises a client to use a corporation for ownership of such appreciating asset.

How a Partnership Entity Can Be Designed To Give Every Benefit of a Corporation

A partnership can be designed as a Limited Partnership, thereby shielding limited partners from claims against their personal assets, just as a corporation does. Only the general partners who actually run the partnership are left with personal liability risks. But general partners may protect themselves from such personal liability risks in various ways. Under applicable laws of the state where the limited partnership is formed, general partners can also obtain personal asset protection by choosing to run the partnership as a limited liability limited partnership, an LLLP. Another way is to have the general partners own shares of an entity created to own the general partnership interests. Such a management company general partner is normally an LLC that will provide personal asset protection for its owners.

 

An LLLP or LLC managed LP can pay a reasonable amount to its members who are active in the business of the entity, with remaining net profits passing through to the owners free of any self-employment and Medicare taxes.

Thus, appreciating assets in such a properly designed entity provides every tax benefit of a S corporation. But it also keeps personal owners from risks to their other assets. It does this better than any corporation since a judgment creditor of a corporation shareholder can attach and take over the shares of the one owning such shares, and if the creditor obtains a controlling interest in the corporation such judgment creditor can take over and liquidate the assets of the corporation to satisfy the judgment against its debtor shareholders. A properly designed limited partnership entity will normally protect against liquidation of the partnership assets to satisfy judgments against the partners because in many states a judgment creditor is limited to taking only profit distributions made by the partnership. 

So choice of where to form the partnership, as well as its design, are important considerations that should be made carefully by qualified advisors.

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