by Bruce Bryen, CPA, CVA
This is a topic that is extremely important to those dentists who may be receiving advice from their dental CPAs or other financial advisors. Incorrect advice may cost thousands of dollars in tax both on a federal, state and local level. The primary and most significant short and long term effects of the differences of each will be part of this article. There are many aspects of each that are similar. Those similarities will not be addressed at length as in the opinion of this author, it is not necessary to do so. The first material item be looked at will be the concept of earned income and the tax based on that amount. With the s corporation, salary to the shareholder is considered to be earned income. The corporation withholds payroll and income tax on a state, federal and sometimes local level. These withholdings come from the wage and the employee retains the net amount. The employer then matches the payroll tax to the employee to a degree based on the federal, state or local requirements for that withholding. These earnings are available for the computation of retirement plan contributions. They are considered earned income so the defined contribution or defined benefit computations are based on these gross amounts. The profit after all expenses is normally taxed to the shareholder as unearned income and is not used to determine deferred compensation amounts.
How does this compare to the LLC?
As an owner/member of an LLC, salary or wages to these personnel are not permitted. The entire amount of the gross revenue minus the expenses equals the amount that is subject to all social security and medicare taxes as well as a potential state payroll tax and any local tax payment. Since there is no owner payroll, the matching tax paid in the above paragraph by the s corporation, is now paid by the individual reporting this income on his or her personal income tax return. Procedurally, this is done so as part of the quarterly estimated payments that include the federal income tax liability for the filer. This is for the federal tax only. From a retirement contribution stand point, since all of the earnings of the LLC are considered earned income, the entire amount is used to determine how much the retirement plan contribution shall be in that year. For the short term, therefore, the s corporation requires a lower tax due based on the earnings of the entity not paid as a wage to the shareholder. The resultant retirement plan contribution is usually lower than that of the LLC owner based on the earned income being lower in the s corporation. Of course if the salary in the s corporation is as high as is allowable for the maximum retirement plan contribution determination, then the shareholder/owner is paying the maximum social security and medicare as well.
Flexibility and cash flow:
When payroll is paid to the shareholder/owner of the s corporation, the payroll taxes and income tax withholding are due at that point. With the profit accounting for the amount of income tax and payroll tax due from the member/owner of the LLC, there is planning time allowed since the taxes from the owner are due quarterly. The opportunity to buy equipment, pay into the retirement account and make other tax effected decisions allow the LLC owner to defer those tax payments almost until the last quarter of the year. This is based on the concepts that are accepted by the owner and put into place by the end of the year. Those funds could be used to pay down debt or to acquire assets needed to enhance the economic value of the dental practice. There is also the flexibility of being able to draw any amount at any time as the owner of the LLC and to determine the ultimate tax for the year based upon planning decisions. When the shareholder of the s corporation wants additional funds, the taxes on those funds must be calculated as if the draw was a salary at some point. The net draw must be “grossed up,” to include and pay the taxes as the draw is taken. Along with these types of decisions, the s corporation has to be concerned with the deductibility of losses according to the basis plus debt due to the shareholder of the company. Any debt of the corporation directly to the lender does not offer the opportunity to use that loan to count towards the basis of the owner’s capital account. If the owner guarantees the s corporation’s debt, that is not good enough. The only issue that the LLC has regarding business debt is that the owner guarantees that liability to its lender. This of course is almost always insisted upon by the lender anyway unless substantial assets are pledged for that loan which has a value well in excess of the loan amount. Examples follow in the next paragraph about outcomes based on equipment loans to the s corporation and to the LLC.
Examples of deductibility of losses to the s corporation and to the LLC: A dentist is purchasing a cerec machine for $150,000 in his or her s corporation and is using the depreciation to throw off a large loss. The loan is to the dental practice and is guaranteed by the dentist. The owner/shareholder has a basis and loans to her from the corporation of $50,000. There is a loss to the s corporation of $100,000. The owner/shareholder can not take the loss in the current year even though she guaranteed the loan from the corporation to the lender because the loss exceeded her basis in the corporation. The result was a loss of $100,000 minus the basis of $50,000, equaling $50,000 that is suspended until the s corporation has another $50,000 worth of basis. Her additional tax in 2020 based on the suspended loss between the federal, state and local levels is about 45% or $22,500. The LLC with the same set of circumstances can deduct the entire loss of $100,000 in the current year so she saves the 45% or $22,500, immediately. There are other comparisons that note worthy as well. It is of critical importance to discuss the differences between the s corporation and the LLC with the dental CPA so that when planning for taxes are discussed, there are no surprises.