Sub S Corps – Tricks and Suggestions.

Date : May 08, 2008

Today I take on my least favorite entity: the Sub S Corporation.

The bottom line is that they are great entities in some cases, but they are almost always terrible if Asset Protection is a goal. I only use them when there is a good reason and Asset Protection is not an issue.

I say this with a bit of a sardonic grin because Asset Protection Corporation is a Sub S corp. Why, if I hate them so much, would my “baby” be Sub S? The answer is simple. My accountant, like most good accountants, thinks it saves a bit on the self-employment tax.

The argument goes as follows: The accountants point out that net profit distributions received by Sub S Corporation shareholders are NOT subject to a self-employment tax while with pass through entities like LLC’s the member must pay self-employment tax on his share of company profits (this is 15.3% of the first 89,900 or income and 2.9% thereafter). The accountants believe that by making the small business owner an employee of the S Corp and setting his salary on the low end of “reasonable,” any dividends in excess of this reasonable compensation level are not subject to self-employment tax. As you can see, the savings can mount up. BTW, I suspect this is one of the issues Obama will be taking on if he becomes president.

Well, shouldn’t I love S Corporations because they can save some self-employment tax? Normally, the answer would be yes. However, I can’t get over two serious hurdles. First: I don’t really understand how Sub S corps are taxed. This should be simple. However, after years of teaching Sub S taxation as an Assistant Professor at the University of Southern California, I can only say that Sub S Corps are a never ending mystery to me. Only a few tax folks (like my CPA) who are on the lunatic fringe of tax accounting can even begin to explain critically important Sub S issues like “inside” versus “outside” basis (this calculation can make a huge difference if you sell or merge your company). Secondly, and most importantly, Sub S corporations CANNOT be owned by Foreign Trusts. Thus, a Sub S Corporation is a terrible entity if it owns anything which you need to protect from creditors. Does this matter to me? NO, because Asset Protection Corporation, like most personal service companies, has little or no value apart from me.

One important rule. NEVER use a Sub S Corporation for an entity which will hold assets you want to protect.

Another interesting side light to Sub S Corps.
Did you know that a plain old LLC can elect to be taxed as a Sub S Corporation if it meets the Sub S operating rules. This is done by having the LLC first elect corporate status (form 8832) and then having it elect Sub S status (form 2553).

An LLC is arguably a more difficult entity to pierce. It has a simpler management structure which works via an operating agreement. In many cases, particularly with multiple member LLC’s, charging order protection may be available. Further, an LLC does not always need officers and directors. Formalities are simply less important with LLC’s. Thus, with a small and simple operation, the LLC electing to be taxed as a Sub S Corporation is simpler to operate. Another technique, approved by the IRS, is to structure the S Corp. ownership so that the S Corp. stock is owned by your LLC and/or Limited Partnership. As long as these entities qualify as “disregarded entities” for tax purpose, they should pass the muster as qualified stockholders.

One thing which sets LLC’s apart from normal Sub S Corporations for Asset Protection purposes is that they can be formed anonymously in some jurisdictions. Simply stated, unless and until the predator coming after you discovers your tax returns, it is difficult or impossible to discover the fact that you own the LLC for tax purposes.

ABOUT THIS EDITOR:

Rob Lambert, Founder and former law professor is considered to be foremost expert on tax compliant asset protection structures. A contributing editor to Lexus Nexus debtor creditors series of law books Rob's passion is implement client wealth plans that stand the test of time and hold up under duress.

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