Protect Your Assets or Pay Less Tax? Now You Can Do Both!
The one thing I love about tax strategy planning is that it never gets boring. This year, 2007, looks to be a very interesting year. That’s because you can throw almost all of your old tax plans out the window if you’re subject to AMT (alternative minimum tax). If your income is over $50,000 for 2007, don’t ignore AMT — you might be subject to it this year.
The best sure-fire way to avoid or minimize AMT is to have a business. And that’s why tens of thousand of people are rushing to start a business before year end. Of course, you have to do it legally — and that’s why I’m featuring what it takes to have a business in the eyes of the IRS so you get all those deductions in this month’s First Class Lounge. There is one more wrinkle to having a business — how do you protect your assets and pay less tax at the same time?
You protect your assets best with business structures. When it comes to protecting assets there are a number of good business structures:
- S Corporation
- C Corporation
- Limited Liability Company (LLC)
- Limited Partnership (LP)
These are structures that protect your personal assets from things that might happen within the business that cause you personal liability.
A Sole Proprietorship (Schedule C) costs you more in tax (15.3% self-employment tax), puts everything you own at risk and is 10 times more likely to create an IRS audit.
A General Partnership (or Joint Venture) is even worse! In this case, you’re liable for everything crazy you might do and you’re also liable for everything crazy your partner might do.
A Corporation (provided it is set up correctly) will protect your personal assets against a lawsuit that comes from the business. But, if something happens personally and you get a judgment, the stock you hold in the corporation could be considered an asset. That means that your personal assets are safe from the business, but your business assets are not safe from you.
An LLC will protect both ways, but the tax benefits aren’t as good. The default tax treatment for an LLC is either Sole Proprietorship or Partnership, which means your earned income from your business is subject to 15.3% self-employment tax.
So, which do you choose: asset protection from an LLC or better tax treatment in a corporation?
Here’s the good news. You don’t need to choose. You can have an LLC that elects to be treated as a corporation — giving you the best of asset protection and tax treatment.
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For an LLC that holds real estate, is the income still considered to be passive rather than earned income for tax purposes and is the partnership type filing election still preferred in this case? Or do you recommend an LLC that holds real estate to elect S-corp tax status?
If you already have an S corp, can you and do you recommend changing it to an LLC for better asset protection? This is assuming there are no plans to take the company to a C corp status. Can an LLC elect a C-corp filing elect to get both asset protection and allowable medical insurance expense deductions for officers/shareholders?
Penny - The LLC taxed as an S Corp is definitely the better business structure for asset protection. There could be an issue on making that change, depending on the state you’re in.
For federal law, you can do a “tax free reorganization” and “roll” assets from the S Corp into the LLC taxed as an S without a tax consequence. Otherwise if you have appreciated assets and you can’t do it tax free, you’ll pay tax on the FMV of the distributed out assets that you put into the new LLC.
This is one of those “don’t try this at home” deals that you want to make sure you follow strictly.
On your second question, an LLC electing S Corp is EXACTLY the same for tax purposes as a plain ol’ S Corp. So, all the benefits, rules, etc stay the same.
A business structure doesn’t change the character of the income. If you have earned income and you’re actively working, it’s still earned income if you put it in an LLC or S Corp.
Same with passive income - if it’s passive income, it’ll be passive no matter how it flows to you.
There are some different rules for C Corps, but I’ll keep it simple…
What is your opinion on using Limited Partnerships to hold cash investments and shift income to children under 5?
How would the distribution of capital gains from the Limited Partnership to the children be taxed? Would it be taxed at kids lower bracket or parents tax bracket?
For instance, let's say at the begining of the year, the child own 10% of the LP. At the end of the year, the LP generates 100K in long-term capital gains and 100K in short-term capital gains. How will the child be taxed?
Ally, you have some good questions. Regarding using a Limited partnership (LP) in general: These are great asset protection devices. The challenge I see, especially for my clients that are business owners or other high risk professionals (doctors for example) is that often an individual ends up being a general partner. General partners have all the risk - not a good idea.
Also, a child under the age of 18 is subject to “kiddie tax” which means that they pay tax at their parent’s tax level. So there is no benefit to moving it other than for estate planning purposes.
Could you please explain how the capital gains are treated in LLC versus S corp. For example, the property is held in LLC, it appreciates in value, I sell it with a profit. The same scenario, but the property held in S corp. Thank you, Elana
Elana, both the LLC (default taxation, I’m assuming) and S Corp are flow through entities. That means when you make income in those entities, the income is reported on your personal income tax return.
So, if you sell an investment that you’ve held for over a year, you’ll pay capital gains tax whether it is sold within an LLC or an S Corp.
Diane,
I am looking at setting up some LLC’s to purchse some properties. Some we will keep as rentals and some we will put under contract and assign to make a little profit. Do you want to set up seperate LLC’s for the rental properties and the assigned. Also, if you elect to treat the LLC as an S Corp do you file the LLC with the state and also the Form 2553 with the Fed? Does your Business Structure cover this information in detail?
Thanks for all your help….