We continue to hear attorneys and CPAs as well as other allegedly "knowledgeable authorities" frivolously recommend the use of an LLC or Subchapter S corporations for real estate investing, when in many cases, that ends up costing their naive clients a lot more in tax dollars. For that reason, it's time for another refresher on some of the big differences between C corporations and S corporations as well as LLCs. Here are some of the more important considerations you should ponder when evaluating which entity will suit your individual situation best.
Tax Brackets: With our country's "progressive" tax rate structure, it is very expensive to have too much income on your personal tax return. For individuals, the nominal rates go from 10% to 38.6% with actual effective rates much higher due to the phasing out of so many tax breaks as income increases.
With an S corp or LLC, all of the income flows right onto the 1040 tax return of the shareholders (members in an LLC), pushing them up into higher tax brackets. On the other hand, a C corporation has its own tax structure, ranging from 15% on the first $50,000 of NET income, to as much as 39%.
Income Taxed: With an S Corporation (or LLC), the shareholders (members in the LLC) are required to pay income tax on their share of the entity's income whether they take any money out of the entity's account or leave it there.
Phantom Income: "C" Corporations can accumulate earnings and pay taxes at the corporate level without the shareholders being individually taxed. On the other hand, if an S Corporation or LLC were to attempt to accumulate earnings, the shareholders or members of the LLC could be subject to " Phantom Income" and therefore be taxed on income not actually received. The " Phantom Income " issue is a simple concept. "Phantom Income" arises where the shareholder or member receives taxable income but no actual money (OUCH!).
Tax Savings: "C"-Corporations are entitled by law to take many tax deductions that are not available to individuals, "S"-Corporations or Limited Liability Companies (LLCs). In addition, "C" corporations have a lower federal tax rate at all levels of income up to $250,000, compared with individuals (only "pass through" entities such as LLCs and "S"-corporations pass the taxable income or losses directly to you). A corporation pays only 15% tax on the first $50,000 dollars of PROFIT (the amount of money left over after all expenses are paid).
More Deductions: IRS Section 179 expensing election is much more lucrative for owners of C corporations because they can literally multiply their total deduction by splitting their purchases of business assets among their different business entities. With an S corp or LLC, the Section 179 deduction is limited to just the one amount. Likewise, the deduction for net rental losses is magnified by using a C corp because it can use rental losses to offset all operating income. This is not the case for S corps as rental losses are subject to the 25% restrictive passive loss rules.
Employee Benefits: One of the benefits of a corporation is having it provide lucrative employee benefits that are deductible by the corp and tax free to the employees. Medical, life insurance, education, childcare, and retirement plans are just a few of the types of benefits available. The tax-free status of some of these plans is much less generous for people owning more than 2% of S corporation stock or an LLC membership than it is for the shareholders and/or employees in a C corp.
Double Taxation: Tax planners continue to spread fear concerning the potential for double taxation with C-corporations. Double taxation comes into play where after-tax earnings of a C corp are distributed to shareholders as non-deductible dividends. This is rarely a problem in small corporations (with earnings under 5 million) and/or non-publicly traded corporations because there are so many legitimate ways to pull money out of the C corp in a manner that is deductible, and thus only taxed once. Some of these are:
- Compensation Plans
- Interest Payments (includes for loans you might make to your entity)
- Lease Payments (includes vehicles, equipment, planes and real estate)
- Contributions to Retirement Plans
- Benefit Plans (including Life and Health Insurance)
- Non-Taxable Reimbursements To You for personal funds you expended on behalf of your entity.
Attack On the Rich: "Mean Testing" (penalizing the evil rich) is a growing trend in this country, and is most often measured by the adjusted gross income (AGI) on your 1040. People over certain income thresholds lose tax breaks and have to pay more taxes and penalties than others do. Income from an S corp or LLC will just make things worse. This is not the case with a C corp.
When it comes to the use of an LLC or "S"-Corp, an old Wendy's commercial said it best:
"WHERE'S THE BEEF"?
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