Alabama LLCs vs. Alabama S-Corporations: S-Corporations Still Useful And Relevant?
Alabama S-Corporations used to be the standard option for attorneys providing their clients with a business entity with limited liability and pass-through taxation. It was the best of both worlds. Business owners would not be personally liable, except in limited circumstances, and the Internal Revenue Service (“IRS”) would not tax the corporation and its shareholders twice. However, since Alabama LLCs have come into existence, one has to ask whether S-Corporations still have a function.
Many attorneys and certified public accountants preferred this entity because it provides tax savings on self-employment taxes (15.3% on the first $128,400 of income in 2018) by taking stock dividends received by the owners or shareholders which are not subject to self-employment taxes. For example, making the owner the employee of the S-Corporation and setting the compensation on the low end they can avoid paying self-employment taxes saving the owner a portion of self-employment taxes and lowering the effective tax rate. On paper, this seemed like a great idea, but due to some other factors, this can create issues come tax time.
Alabama S-Corporation Owners Must Have A “Reasonable” Salary
When setting the salary for an owner or owners, the IRS requires that the pay must be reasonable. Reasonable is a very vague term, and the IRS spends a fair amount of time litigating and auditing businesses in this area. There is no hard and fast rule. The courts and the IRS use many factors to determine reasonable compensation including, but not limited to the type of business, employee performance, company conditions, time and effort devoted to the business, employee qualifications, and compensation compared to non-shareholder employees. Each business is not the same, so reasonable compensation for one business owner will not look like another’s.
Alabama S-Corporations Will Still Pay The Reasonable Salary Regardless of Financial Conditions
Alabama S-Corporations are typically a bad idea for those just starting a business unless you will be profitable on day one. For most companies that does not happen. Owners are usually working without taking salaries to help make the company profitable. If you choose an S-Corporation, you will pay yourself a salary from day one, making the company’s overhead larger and potentially going further in debt. That hurts the company’s chances to become a long-term, profitable business that all dream to own.
Alabama LLCs Are Better Options 99.9% Of The Time to Alabama S-Corporations
LLCs are now the most popular business entity choice for business owners. The reason is that it can do most of the things that an S-Corporation can, but without the requirements and formalities. The IRS can tax an LLC as an S-Corporation when the LLC completes IRS Form 8832 choosing that option. That means that once your LLC is growing to where you can pay a salary, you can get the self-employment tax benefits without changing the business entity.
Here are a few more reasons an LLC is preferable to an S-Corporation:
- An S-Corporation has a better chance of losing its limited liability, which protects the owners from personal responsibility in most cases. An S-Corporation must follow corporate formalities like regular meetings, while an LLC usually does not. Failure to follow the corporate formalities could trigger a legal theory called “piercing the corporate veil” which strips away the corporation’s limited liability. That means the owners can become personally liable at that point.
- Usually, when someone sues a corporation, they name the owners, officers, and directors personally in the lawsuit. In the pleadings, attorneys claim these players committed negligence or gross negligence. Such claims lead to higher settlements to forego the discovery process for these people. LLCs can circumvent this by having the management form another LLC to create another layer of limited liability so that lawsuit names no living person unless a court pierces the corporate veil.
- S-Corporation stock is personal property. Judgment creditors of a stockholder can seize S-Corporation stock. LLC membership interests are usually exempt from outright seizure.
- Because of the simple management structure and lack of formalities, LLCs are easier to operate.
LLCs have made S-Corporations obsolete in almost all cases. S-Corporations now become preferable when an owner wants to transfer ownership and stock quickly and easily. Due to the number of owners in an S-Corporation, this rarely occurs.
Should you need help deciding what entity to choose, please call us at (205) 598-1810, or schedule a strategy session.
Joshua Key is the owner of Key Law, LLC and an estate planning and business attorney. He is a speaker, a blogger, a husband, a father, a pilot, and helps people create the life and business of their dreams.
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