Taxation of a partnership versus S Corp in NJ

[jmt111]

What is the name of your state? NJ

I have an LLC with 2 members, which I understand can file its taxes in NJ as a partnership or as an S Corp.

What are the advantages and disadvantages of each? I understand that filing as an S Corp requires submitting a balance sheet and filing as a partnership allows for pass-through taxation, which means that the partnership itself is not taxed, but the profits flow through to the partners who are taxed on the profits they receive from the partnership. Are there any other differences?

 

[FlyingRon]

As long as you do things right, both have no taxation for the LLC. The difference is how the members treat their income. A partnership member is not an employee, but receives a K-1 indicating their share of the income. An S corp member who performs work for the corporation, is an employee and gets normal employee treatment for the fair market value of their work. Any additional LLC profit gets treated as a dividend for the members.

NJ has the same filing requirements whether you are treating your LLC as a S corp or Partnership. NJ and the Feds require filings for the LLC as well and this varies for partnerships or LLCs, but in neither case would I call it a "balance sheet" nor doesdo you get disregarded.

 

[Taxing Matters]

What is the name of your state? NJ

I have an LLC with 2 members, which I understand can file its taxes in NJ as a partnership or as an S Corp.

What are the advantages and disadvantages of each? I understand that filing as an S Corp requires submitting a balance sheet and filing as a partnership allows for pass-through taxation, which means that the partnership itself is not taxed, but the profits flow through to the partners who are taxed on the profits they receive from the partnership. Are there any other differences?

Both are very similar in that they both provide for pass through taxation (that is, the LLC won't pay any income tax; rather the profit or loss is passed through to the owners and goes on their return). S-corporation taxation works much the same as partnership tax, too. As a result, the tax rates on the income are the same, too. However, as Ron mentioned with the S-corporation the owners who do work for the corporation are treated as employees and thus the corporation must withhold and pay employment taxes on the salary/wages earned like with any other employee. The rule is that all distributions to the shareholder are treated as employee compensation up to the point where the shareholder has received reasonable compensation for all work that he/she has ever done for the corporation. When the corporation starts doing very well this can be an advantage in saving on a bit of FICA (Social Security and Medicare) taxes, depending on the details of how the corporation makes its money. Note, however, that current shareholder losses of an S-corporation are limited to the shareholder's basis in the corporation. That can be a significant factor for a new business that expects to run losses the first year or two. These two facts are the reason why businesses often start out with the LLC taxed as a partnership and then convert to S-corporation later when the corporation starts doing well.

I suggest you meet with a tax lawyer or other tax professional familiar with partnership and S-corporation taxation to review the details of your business and get advice on which way to go as well as advice what other tax issues your business may have.

Any additional LLC profit gets treated as a dividend for the members.

Well, technically no. S-corporations don't pay dividends (i.e. their shareholders do not receive distributions that are taxed as dividends). That is the big advantage of a S-corporation over a C-corporation. The distributions are simply distributions under the Code and will decrease basis. Distributions in excess of basis result in gain to the shareholder. But none of the distribution is considered a dividend for income tax purposes, though the corporation might call it a dividend.

 

[jmt111]

Suppose an LLC is owned and operated by 2 member-employees. Isn’t it better to elect to be taxed as a partnership rather than as an S corporation because as a partnership, the owners who are employed by the business are considered business owners, not employees, whereas with an S corporation, the owners are considered employees and their wages become subject to FICA tax for Social Security and Medicare and to taxation under the Self-Employed Contributions Act (“SECA”)? To avoid such taxation, it is better to organize as a partnership, so that all of the payments made to the owners are taxed as dividend income that avoids FICA and SECA taxes?

Taxing Matters wrote, “When the corporation starts doing very well this can be an advantage in saving on a bit of FICA (Social Security and Medicare) taxes, depending on the details of how the corporation makes its money.” I am not sure I see how this is the case. If the owners work for the LLC as employees, then they must pay FICA tax for Social Security and Medicare on their wages. If they want to save on these taxes, shouldn’t they elect for taxation as a partnership, where they are not treated as employees, and thereby avoid FICA taxes?

 

[Zigner]

You would be wise to consult with a local pro about your matter. A CPA.

 

[Taxing Matters]

Suppose an LLC is owned and operated by 2 member-employees. Isn’t it better to elect to be taxed as a partnership rather than as an S corporation because as a partnership, the owners who are employed by the business are considered business owners, not employees, whereas with an S corporation, the owners are considered employees and their wages become subject to FICA tax for Social Security and Medicare and to taxation under the Self-Employed Contributions Act (“SECA”)?

No, that's not correct. S corporation shareholders are NOT subject to self-employment (SE) tax. SE tax is, of course, how self employed persons pay their FICA taxes (Social Security and Medicare taxes). But S corporation shareholders are not self-employed. To the extent they do work for the business, they are considered employees and subject to FICA taxes. So they are subject to FICA withholding on their earnings with the corporation paying its matching share of the FICA tax. They are not subject to SE tax in addition to the FICA taxes. Indeed, you are never subject to both FICA tax and SE on the same income.

To avoid such taxation, it is better to organize as a partnership, so that all of the payments made to the owners are taxed as dividend income that avoids FICA and SECA taxes?

Again, you are incorrect. Partners of a partnership are not employees of their partnerships. So there is no FICA withholding for their share of partnership profits. Instead, active partners (those that actually do work for the partnership) are subject to SE tax on their entire share of partnership profit.

So either way, Social Security and Medicare taxes are paid. With the S corporation, that's done with the FICA withholding on the wages of the corporate shareholder-employee. With a corporation, that's done by the SE tax that the partner pays on his/her share of the partnership profit.

Taxing Matters wrote, “When the corporation starts doing very well this can be an advantage in saving on a bit of FICA (Social Security and Medicare) taxes, depending on the details of how the corporation makes its money.” I am not sure I see how this is the case. If the owners work for the LLC as employees, then they must pay FICA tax for Social Security and Medicare on their wages. If they want to save on these taxes, shouldn’t they elect for taxation as a partnership, where they are not treated as employees, and thereby avoid FICA taxes?

Again, partners of a partnership do pay SE tax on their share of the partnership profit, and thus they pay Social Security and Medicare taxes. The tax rates are effectively the same for both. So you are going to have to pay that either way. The difference, however, is the base on which the tax is computed. For the S corporation shareholder who is an employee, the taxes are computed on his/her gross wages. For the partner of a partnership, it's his/her share of net profit of the partnership.

I'll give you an example that is simplified to illustrate the difference. Suppose that Joe and Steve are each a 50% shareholder of XYZ LLC that is taxed as a S corporation. They both are managing members of the corporation and do similar work for the corporation. The corporation would have had a net profit of $200,000 if it didn't have to pay Joe and Steve for the work they did, so each would have had $100,000 in net income from it. The reasonable compensation for the work they did (i.e. what they could have hired someone of similar skill to do the same work) is $85,000. So the corporation pays them each a salary of $85,000 for the year. The total FICA taxes for each them (the part withheld from their pay plus the corporate matching share) is 15.3% so Joe and Steve each pay $13,005 in FICA taxes. The corporation deducts the $85,000 in salary paid to each of them, so they now only have $15,000 in net income from the corporation on their return but they have $85,000 in salary, so in the end they both still end up with $100,000 of income on which they pay income tax.

Now assume that they instead operated as a partnership. Now they are not employees and do not get paid any salary. They each have $100,000 of net income from the partnership to include on their income tax return. They also must pay SE tax on that $100,000 of net income. So they pay 15.3% of $100,000 (actually just slightly less due to a quirk in computing the SE tax that I'm ignoring to illustrate the principle), so they end up paying $15,300 in SE tax.

So the bottom line here is that with both the S corporation and partnership they ended up with $100,000 of net income for income tax purposes. But what they pay in Social Security and Medicare tax is different. With the S corporation, they paid only $13,005 because the FICA tax is computed on the salary paid, not their entire profit. With the partnership they paid $15,300 of SE tax because that tax is computed on their entire net income from the partnership. Using the S corporation thus saved them each $2,295 in Social Security and Medicare tax because of that difference in what is used as the base for computing the tax.

Of course this is a very simplified example, and there are other things to consider when making the choice between S corporation and partnership than just the FICA/SE tax issue. Which is why you want to meet with a business attorney and tax attorney or other tax professional familiar with business taxation for advice on which is better to use for you right now. Bear in mind that it is pretty easy to convert from partnership to S corporation so you could start with a partnership and convert to S-corporation later on. That's what many small businesses do.

 

[LdiJ]

No, that's not correct. S corporation shareholders are NOT subject to self-employment (SE) tax. SE tax is, of course, how self employed persons pay their FICA taxes (Social Security and Medicare taxes). But S corporation shareholders are not self-employed. To the extent they do work for the business, they are considered employees and subject to FICA taxes. So they are subject to FICA withholding on their earnings with the corporation paying its matching share of the FICA tax. They are not subject to SE tax in addition to the FICA taxes. Indeed, you are never subject to both FICA tax and SE on the same income.



Again, you are incorrect. Partners of a partnership are not employees of their partnerships. So there is no FICA withholding for their share of partnership profits. Instead, active partners (those that actually do work for the partnership) are subject to SE tax on their entire share of partnership profit.

So either way, Social Security and Medicare taxes are paid. With the S corporation, that's done with the FICA withholding on the wages of the corporate shareholder-employee. With a corporation, that's done by the SE tax that the partner pays on his/her share of the partnership profit.



Again, partners of a partnership do pay SE tax on their share of the partnership profit, and thus they pay Social Security and Medicare taxes. The tax rates are effectively the same for both. So you are going to have to pay that either way. The difference, however, is the base on which the tax is computed. For the S corporation shareholder who is an employee, the taxes are computed on his/her gross wages. For the partner of a partnership, it's his/her share of net profit of the partnership.

I'll give you an example that is simplified to illustrate the difference. Suppose that Joe and Steve are each a 50% shareholder of XYZ LLC that is taxed as a S corporation. They both are managing members of the corporation and do similar work for the corporation. The corporation would have had a net profit of $200,000 if it didn't have to pay Joe and Steve for the work they did, so each would have had $100,000 in net income from it. The reasonable compensation for the work they did (i.e. what they could have hired someone of similar skill to do the same work) is $85,000. So the corporation pays them each a salary of $85,000 for the year. The total FICA taxes for each them (the part withheld from their pay plus the corporate matching share) is 15.3% so Joe and Steve each pay $13,005 in FICA taxes. The corporation deducts the $85,000 in salary paid to each of them, so they now only have $15,000 in net income from the corporation on their return but they have $85,000 in salary, so in the end they both still end up with $100,000 of income on which they pay income tax.

Now assume that they instead operated as a partnership. Now they are not employees and do not get paid any salary. They each have $100,000 of net income from the partnership to include on their income tax return. They also must pay SE tax on that $100,000 of net income. So they pay 15.3% of $100,000 (actually just slightly less due to a quirk in computing the SE tax that I'm ignoring to illustrate the principle), so they end up paying $15,300 in SE tax.

So the bottom line here is that with both the S corporation and partnership they ended up with $100,000 of net income for income tax purposes. But what they pay in Social Security and Medicare tax is different. With the S corporation, they paid only $13,005 because the FICA tax is computed on the salary paid, not their entire profit. With the partnership they paid $15,300 of SE tax because that tax is computed on their entire net income from the partnership. Using the S corporation thus saved them each $2,295 in Social Security and Medicare tax because of that difference in what is used as the base for computing the tax.

Of course this is a very simplified example, and there are other things to consider when making the choice between S corporation and partnership than just the FICA/SE tax issue. Which is why you want to meet with a business attorney and tax attorney or other tax professional familiar with business taxation for advice on which is better to use for you right now. Bear in mind that it is pretty easy to convert from partnership to S corporation so you could start with a partnership and convert to S-corporation later on. That's what many small businesses do.

That is one of the best examples I have seen of that particular issue.

 

[Taxing Matters]

That is one of the best examples I have seen of that particular issue.

Thank you. I tried to keep it simple to illustrate the principle; that's a challenge with subjects like this where it's easy to get bogged down in the details of computations.