Our last post discussed self-employment (SE) tax and taxpayers’ efforts to avoid that tax when using an entity taxed as a partnership to conduct business. It concluded that a limited partnership that conducted business directly or through an LLC was safer than using an LLC. Although the case we discussed involved one passive taxpayer who prevailed, being passive risks imposition of a 3.8% tax on net investment income.
Many taxpayers instead have turned to doing business as an S corporation. S corporation income is not subject to SE tax. However, any compensation the owner receives is subject to FICA tax, which imposes an equivalent burden. And the IRS frequently attacks owners who receive cash distributions from an S corporation, arguing that the distributions were essentially disguised compensation. The IRS often wins those cases, in full or in part, and may collect penalties.
In Fleischer v. Commissioner, Tax Court Memorandum 2016-238, a financial industry services professional failed to get the IRS and the Tax Court to respect his attempt to shift income to an S corporation to save SE tax. The agreements that generated the income were with the professional himself — not with the S corporation.
I provided some additional in-depth commentary on the Fleischer ruling for Steve Leimberg’s Business Entities Newsletter: Steve Gorin on Fleischer v. Commissioner: Using an S Corporation to Limit Self-Employment Tax Imposed on Financial Industry Services Compensation.
But, to put it briefly, when a business is in its early stages, using an S corporation to avoid SE tax might not make sense. Businesses often lose money initially, and S corporation owners have more difficulty writing off debt- financed losses. After that, the business might not earn much more than what it should be paying as compensation anyway. And, if the business is sold to employees, an entity taxed as a partnership can save significant tax relative to the sale of S corporation stock. If the owner dies, using an S corporation might deprive the business of write-offs the owner’s beneficiaries would otherwise have received; see our previous post, “Tax basis: The key to reducing gain on sale or deducting asset purchases.”
In many cases, it might make sense to start as a limited liability company (LLC) that is disregarded for income tax purposes or taxed as a partnership. Later, the LLC can be transferred to a limited partnership to save SE tax in a tax-free transaction that is much simpler to accomplish than transforming from a corporation to a partnership structure.