Landlords and property managers seeking to limit their personal liability for tenant claims often consider forming a corporation or limited liability company. This post compares the two options so an intelligent choice can be made.
For more information on protecting assets and limiting liability, see our blawg post Protection of Assets.
- Payroll deductions from stockholders’ salaries instead of paying estimated taxes.
- Fringe benefits:
- A corporation which does not elect Subchapter S tax treatment can provide stockholder employees with benefits that are not taxable to them and which are deductible by the corporation, such as health insurance, life insurance, etc.
- Benefits such as life insurance, health and accident insurance, medical reimbursements and the like are treated as expenses of the owners. The costs are not tax deductible, with the exception of health insurance, which is partially deductible.
- If a stockholder owns the firm’s company’s office space, the stockholder can receive rent from the corporation which will not be subject to withholding taxes but will necessitate estimated income tax payments.
- Insulation from personal financial liability.
Annual maintenance – filing of annual registration report with the Secretary of State and documenting at least annual meetings of stockholders and directors.
If corporation is profitable, its stockholders can receive a return on their investment through the payment of dividends. Dividends must be approved by the board of directors and are taxable to the stockholders as ordinary income.
Dividends are not the only way stockholders can receive money from a corporation. Additional possibilities include:
- A stockholder can be paid a salary if employed by the corporation. If the salary is reasonable, it will be a deductible expense in its entirety for the corporation. Of course, the salary will be taxable to the stockholder.
- If a stockholder has loaned money to the corporation (as distinct from purchasing stock), the corporation’s principal repayments will be non-taxable to the stockholder while the interest payments will be taxable. The corporation can deduct the interest payments but not the principal payments.
- If a stockholder leases real or personal property to the corporation, the rent payments will be deductible for the corporation and taxable to the stockholder.
Unless a corporation elects special tax treatment under Subchapter S of the Internal Revenue Code, the corporation’s net income is subject to taxation at rates sometimes higher than those applying to individuals. This raises the possibility of double taxation of dividends – the money is taxed once at the corporate level and again at the personal level when reported on stockholders’ personal tax returns.
To avoid this consequence, many stockholders in corporations which have not elected Subchapter S treatment ensure that all net income is paid out to the stockholders in the form of dividends, bonuses or salary before the end of the year. Then, if necessary, the stockholders can loan money back to the corporation at the beginning of the next calendar year to provide necessary operating capital; these loans can be paid off during the year as money becomes available.
Another way to avoid the double-taxation effect, subject to certain restrictions, is to elect corporate tax treatment under Subchapter S of the Internal Revenue Code. If this election is made, the corporation is treated virtually the same as a partnership for tax purposes. Although the corporation must file an informational return with the IRS, its net income is not taxed at the corporate level but rather is “passed through” to the stockholders for reporting on their personal returns. Corporate losses can also pass through and be taken as losses on the stockholders’ personal returns. If a corporation elects Subchapter S, health insurance and other benefits will be taxable to stockholders and not deductible by the corporation. Consultation with an accountant is highly recommended before deciding whether to elect Subchapter S.
Limited Liability Companies
A limited liability company (LLC) is a relatively new form of business organization allowed in Missouri.
In concept, an LLC functions much like a partnership, but it has most of the advantages of a corporation in terms of limiting the individual liability of its owners for business obligations.
An LLC is formed by filing relatively simple Articles of Organization with the Secretary of State. The owners of the LLC, who are called members, manage the company unless they agree in the Articles of Organization to provide for centralized management by one or more managers. The statutes also require the members of an LLC to adopt an Operating Agreement. The Operating Agreement covers such matters as governance, capital contributions, sharing of profits and losses, admission of new members, and buy-outs of existing members.
Advantages of LLC Compared with Corporation
- Income distribution need not be proportional to ownership interests. This is in contrast to partnerships, where tax rules require allocation of profits and losses in proportion to ownership interests, and corporations, where corporate law requires dividends to be paid in proportion to stock ownership (although corporations can pay varying amounts of salary to stockholder-owners).
- Many of the on-going formalities required in a corporation are not required of an LLC. There are no requirements for annual registration or formal documentation of company decisions.
- An LLC can elect in its Articles of Organization to be treated much like a partnership for tax purposes, whereas a corporation must file a special Subchapter S election with the Internal Revenue Service to achieve similar tax treatment. An LLC which elects partnership tax treatment does not pay tax itself, but reports its income (or loss) on an informational tax return which also allocates the income or loss to the owners. The owners then report the income or loss on their personal tax returns.
- An LLC also can elect to be taxed as if it were a corporation. If it does so, it can make a further election for Subchapter S treatment.
Disadvantages of LLCs Compared with Corporations
An LLC can be more expensive and time-consuming to set up initially. This is because the higher degree of flexibility in organizing an LLC may require a more complicated organizational document (Operating Agreement), which must be tailored to meet the organizers’ particular desires.
Because LLCs are a relatively new phenomenon, there are some unresolved questions about how particular legal issues will be resolved by the courts when they arise through litigation. However, most practitioners now believe that issues not yet addressed by appellate decisions will be resolved in general accordance with the body of law governing corporations.
Caveat: Personal Guarantees
As noted above, stockholders in a corporation and members of an LLC are generally shielded from entity-level obligations.
However, for small companies, corporate stockholders and LLC members are commonly required to give personal guarantees for such obligations as leases or loans, but that will occur by agreement and not by operation of law.
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