Resisting the Lure of S Corporations

As I discussed in an earlier writing, an LLC taxable as a partnership is the superior choice of entity when the entity will own Appreciating Assets. The reasons are numerous and compelling. However, some tax advisors advocate S corporations because (1) an S corporation can pay its owners W-2 income (a tax partnership cannot) and (2) dividends from an S corporation are not currently subject to FUTA, FICA, and Medicare. If the entity only provides services and has no Appreciating Assets, this lure to S corporation status is enticing.

However, please consider two issues. First, can you be sure even a service entity will not create intangible Appreciating Assets (for example, goodwill, going-concern, customer lists, and intellectual property)? If such assets arise, an S corporation is an inferior choice to an LLC taxed as a tax partnership. Second, the owners of most entities should concentrate first on maximizing their pension plan contribution rather than saving withholding taxes. Thus, in the S corporation context, the owner should determine what amount of W-2 wages is necessary to allow the maximum pension contribution the owner can comfortably make. Only amounts above that level should be allocated and distributed as dividends. If you do the math, you will probably discover that the S corporation only saves a modest amount of Medicare taxes. In most situations, the tax risk of potentially putting intangible Appreciating Assets in an S corporation outweighs Medicare savings. If the total return to the owners grows significantly, an LLC taxable as a partnership can easily change to an accommodating structure.

Some tax advisors may believe significant pension contributions will not be made near term and may continue to advocate S corporations for pure service businesses. Reasonable minds can differ. However, if your entity is going to be an S corporation, please organize it as a corporation. At least this form will warn future advisors that the entity is a corporation. Tax law does allow an S corporation to be organized as an LLC and then to elect to be an S corporation. If for whatever reason you insist on organizing LLCs and then making them S corporations, please (1) make sure that your operating agreement protects the S corporation status (for example, limits members to eligible shareholders and only provides one class of equity) and (2) place a warning on the footer of the operating agreement that states "This LLC has elected to be an S corporation."