Multiple LLC’s with a controlling S Corporation

One of the more flexible capital arrangements I have used is the formation of multiple LLC’s, each to accomplish some function or equity interest, with the taxpayer’s interest being held by a controlling S Corporation. This provides an enormous amount of flexibility in that each LLC can have unique financial arrangements, partners, etc., and the income portion that flows to the taxpayer is protected and managed using the S Corporation. The S Corporation will protect the individual stockholder from excessive self employment taxes, and allow a consolidation effect of the earnings and losses of the various LLC’s. Financially this allows the client to enter into customized financial arrangements with others to operate businesses or make investments without involving the core S Corporation.

Special Allocations; Profit Interests

The technicalities and potential dangers of using special allocations, and my favorite, variable profit interest (as opposed to capital interests) scares the pants off many general practitioners, yet they provide extremely powerful tools to manage and arrange tax liability. The most common mistake is assuming capital interests are the only way to divide income, losses or items of taxation. That is not the case at all, and changing, evolving allocations of income and loss are very beneficial to tax savings and rewarding LLC members.

An LLC’s default tax status is a disregarded entity if a single member, or a partnership if multiple member interests. Partnership taxation provides the ultimate flexibility in arranging taxation. Properly used, the flexibility of an LLC can pay dividends.

I am frequently involved in the design and review of LLC structures, profit interests and similar arrangements, and periodic reviews for IRC compliance.

Check the Box Elections; 1120S after 1065

Did you know that an LLC can be converted to an S Corporation with 1 form? There is no reason to create a new corporation, but there are tricks and traps to the practice.

One of my favorite techniques is to use an LLC as a partnership or disregarded entity while losses are being produced, and then switch by election to S Corp when profits are starting, in order to avoid self-employment taxes. The LLC uses partnership rules for basis in losses rather than the S Corp, allowing the LLC member to count his/her share of liabilities as basis, and get more loss deduction. (You must be careful; see Check the Box Incorporations for details.)

Self Employment Taxes and LLC’s

As LLC with two equal members that both work in the business will have 100% of their earnings taxed for self employment purposes, but if they used and S corporation as the entity for the exact same business, their employment taxes would be limited to “reasonable compensation.”

Since there is no limit to the application of Medicare taxes to self employment income, an LLC with $400,000 in income would subject its owners to a tax of 2.9% X $400,000, or $11,600 each. The same business, if an S Corporation with salaries of $100,000 each, would incur only $2,900 each for Medicare tax for the same income. That savings of $8700 per owner would apply each and every year, forever.

LLC’s are valuable, flexible business entities, but it is important to consider all taxes with their use. I am involved on a regular basis with “after
the fact rehabilitation” efforts to minimize or reverse inadvertent or miss-informed LLC formations. The best advice “prevention is always better than a cure”!

“Check the Box” Incorporations

The IRS regulations provide great flexibility and convenience in allowing entities to change their tax status via election, by “checking the box” on
form 8832. An LLC, previously taxed as a partnership or discarded entity, can elect to be taxed as a corporation, and by election, to be taxed as an S Corporation. Now this is a wonderful and useful tool. The entity is still legally an LLC, but it has elected to be taxed as an S Corporation, and its taxation has moved from Subchapter K of the Internal Revenue Code to Subchapter S.

The Code, the diverse and devilish creature that it is, has a special set of ruled to handle this transaction, and one of the ruled is that the “incorporation” is deemed to have occurred on the day before the election is to go into effect. This means if you file the 8832 effective January 1, the transfer of assets and liabilities from the partnership is deemed to occur on December 31. Okay so far? Now what if the LLC, taxed as a partnership, had liabilities in excess of the tax basis of its assets? (Not fair market value, tax basis). Then the Code holds that you just created a gain under Section 357 (c), in the prior year!

Are there ways to avoid this trap? Yes, but they are not what you might imagine, and you will have to hire me to find out.