A small business owner has a number of withdrawal methods available when seeking to minimize the amount of vulnerable assets within an entity by withdrawing funds from the business.
Salary payments are the most common form of withdrawal for small business owners. Constructive fraud provisions do not limit the payment of salaries because this income is by definition in exchange for return value (i.e., time spent working for the business). However, the Uniform Fraudulent Transfers Act's actual fraud provisions, and the financial tests associated with them, still apply to these types of withdrawals from the business. One of the best ways to prevent a finding of actual fraod is to make these withdrawals regular and in writing. Good recordkeeping will go a long way toward proving the validity of these withdrawals.
IRS rules limit payments to reasonable compensation, and the courts have consistently allowed rather high salaries to the owners of small businesses. However, the entity structure has tax ramifications. All the earnings of a limited liability company (LLC) are subject to the self-employment tax, as opposed to a corporation where the tax is imposed only on salary paid to the owners. This difference can affect how you structure the withdrawals from your business based on the form you do business in.
Salary tax issues for corporations
In a corporation, the employment tax is imposed only on actual salary paid to the owners. Thus, the employment tax liability can be avoided by distributing earnings (i.e., dividends) to the owners rather than paying salary for services rendered. Moreover, because small business owners who operate a corporation usually will elect Subchapter S corporation tax status, there will be no double tax on dividends.
The advantage of paying dividends (i.e., avoiding the employment tax) must be weighed against the disadvantage of distributing earnings, as opposed to paying salary. In particular, payment of salary avoids the constructive fraud provisions in the Uniform Fraudulent Transfers Act (UFTA) and the stringent state corporation statutes imposed on distributions of earnings.
In addition, salary earned or accrued is exempt under many state post-judgment exemptions, as well as under federal bankruptcy exemptions, subject to certain limits. Distributions of earnings or dividends will not normally meet the definition of "wages" or "salary," and therefore will not be exempt. Thus, from an asset protection viewpoint, payment of salary offers advantages in asset exemption planning over mere distributions of earnings.
Of course, elimination of taxes is a form of asset protection (through the use of trusts, the choice of organizational form, and planning for estate taxes). Thus, small business owners must weigh the relative benefits of each form of asset protection.
As a general rule, in the early years of a business, when the corporation is likely to be technically insolvent, or have no net income, and thus no earned surplus or retained earnings if it is a corporation, it may be wise to pay salary, so that the constructive fraud provisions under the UFTA or the state's corporation statute will not apply. It also qualifies the distributions under the state and federal exemption provisions in the event the business fails, resulting in litigation or, possibly, a bankruptcy filing
As the business grows, and thrives, producing regular and substantial income, withdrawals in the form of distributions of earnings may be a better alternative than payment of salary, because these payments avoid the self-employment tax. In addition, the constructive fraud provisions will not be a real issue due to the business's sound financial position.
Overall, a better, more complementary approach, that works in both the early and more productive years of a business entity, is withdrawal of funds as loan and lease payments.
Salary tax issues for the LLC
Generally, the earnings of the limited liability company (LLC) will be subject to the self-employment tax, regardless of whether or how these earnings are distributed. Therefore, there is no self-employment tax advantage to distributing earnings as opposed to paying salary. In other words, there is no disadvantage, as far as self-employment taxes are concerned, to paying salary as opposed to distributing earnings. However, because the state LLC statutes usually impose the same constructive fraud test as the Uniform Fraudulent Transfers Act (UFTA), the paying of salary in the LLC also does not confer any advantage.
In contrast, the state corporation statutes impose more stringent balance sheet tests than what is imposed by the UFTA. Thus, in the case of the corporation, the payment of salary confers a benefit, because salary is not paid on account of an ownership interest, and thus helps you to avoid the state corporation statutes' more stringent balance sheet tests.
Nevertheless, similar to the corporation, an LLC's payment of salary, as opposed to distribution of earnings, does qualify the distribution under the state and federal asset exemption provisions. Thus, especially because there are no self-employment tax disadvantages, overall, payment of salary is the better alternative in the LLC.
Finally, an effort should be made to structure the LLC's payments of salary as "guaranteed payments."
As with the corporation, the approach that may be best--in both the early and more productive years of a business entity--is withdrawal of funds as loan and lease payments.
Guaranteed payments can withdraw funds from multi-owner LLCs
The small business owner should be familiar with the tax code concept of "guaranteed payments" and how it applies to the multi-owner limited liability company (LLC). Whether payments for salary, loans and leases constitute guaranteed payments will affect the tax basis of each owner, and exactly how the information return of the LLC will report the payments.
Specifically, payments to an owner, on account of his ownership interest, reduce the owner's tax basis in the LLC. A lower tax basis will mean higher taxable gain when the equity interest is later sold .In contrast, payments to an owner for guaranteed payments do not cause a reduction in tax basis, because these payments are made to an owner other than in his capacity as an owner (i.e., as an employee, lender or lessor). Thus, usually, it is better to structure salary, loan and lease payments as guaranteed payments.
In addition, guaranteed payments are deducted, along with other expenses, on the LLC's information return filed with the IRS. When payments are not guaranteed payments, they are not deducted on the information return and, instead, are disclosed as part of the allocation of net income to each owner. The owners receive the same amounts in either case, but the reporting is different.
Generally, guaranteed payments are payments made to the owners other than in their capacity as owners and without reference to the LLC's earnings. Thus, usually, payments for salary, loans and leases should qualify as guaranteed payments.
However, when a salary is stated simply as a percentage of profits, this may appear to be just a way of dividing income. Thus, in this case, the salary may not qualify as a guaranteed payment. For example, if an agreement provided that one owner in a two-owner LLC was to receive a "salary" of 50 percent of the LLC's earnings, with the other 50 percent allocated to the other owner, this "salary" would be unlikely to constitute a guaranteed payment.
John and his partner each own half of an LLC. John receives a salary of $100,000 from his LLC. The LLC's income, before deducting this payment, is $400,000.
Let's say John's $100,000 salary is a guaranteed payment. On its information return filed with the IRS, the LLC reports income of $300,000 ($400,000 less the $100,000), of which $150,000 is allocated to each owner.
Thus, John has income from the LLC of $250,000 ($100,000 plus $150,000), while his partner's share is $150,000. John would separately report the salary of $100,000 as wage income and the $150,000 as his share of the LLC's income. He would pay self-employment tax on the total received, $250,000, as generally all of an owner's share of the LLC's earnings, whether an allocated share of income or a guaranteed payment, is subject to self-employment tax. (Payments for loans and leases may avoid the self-employment tax).
John must reduce the tax basis of his equity interest in the LLC only by the amount of his share of the distributed earnings, or $150,000, rather than the $250,000 he received, because the $100,000 is salary and not a distribution on account of an ownership interest.
If the salary were not classified as a guaranteed payment, John and his partner still would still receive the same $250,000 and $150,000, respectively. However, now each partner would reduce the tax basis of his equity interest by the full amount received, because all of the payments would be on account of their ownership interests. Thus, John would reduce his tax basis by $250,000, rather than $150,000.
In addition, now the $100,000 would not be reported as a deduction for salary on the LLC's information return. Instead, the information return would show income of $400,000, with $250,000 allocated to John, and the remaining $150,000 allocated to his partner.
Withdraw cash by selling accounts receivable
Still another strategy exists for businesses that generate a large volume of accounts receivables. This strategy is based, in part, on a concept termed "securitization." The strategy involves the sale of receivables by the operating entity to the holding entity (or to the owner, personally, if no holding entity is used). Cash is paid into the operating entity for the purchase of its accounts receivables, and then quickly withdrawn by the owner as payments for salary, leases and loans, operating expenses, etc. In this way, vulnerable assets (i.e., the accounts receivable) are not left for any appreciable time within the form of the operating entity, where they would be vulnerable to the claims of the operating entity's creditors. (See our discussion of Using Holding and Operating Companies to Protect Business Assets.)
Loans and leases legitimately move money from business
Courts have consistently held that payments for loans and leases are legitimate expenses. These expenses allow the owner to withdraw vulnerable funds from the operation, instead of allowing them to accrue and making them a target. Using loans and leases to withdraw money from the business has multiple advantages for the small business owner.
From an asset protection standpoint, physical property secured by loans and leases running to the owner will not be lost to a creditor when the business owner is also a secured creditor for the property. (See our discussion of Funding Entities to Maximize Asset Protection). When creditors line up, the business owner will be among the first in line.
In addition, payments from corporations for loans and leases are exempt from employment tax if the recipient is not in the regular business of extending loans or leasing property. The limited liability company (LLC) enjoys the same self-employment tax advantage as a corporation when it makes payments for leases and loans, but only in specific circumstances.
Loan/Lease tax issues for the corporation
Because loan and lease transactions are for return value (similar to payments for salary), they are not subject to the Uniform Fraudulent Transfers Act's constructive fraud provisions. Moreover, these distributions aren't made to owners on account of their ownership interests (again, similar to salary). Thus, the distributions also are not subject to the constructive fraud restrictions imposed by state corporation and LLC statutes.
Self-employment tax regulations exempt payment for loans and leases, where the recipient is not in the regular business of extending loans or leasing property. Therefore, in contrast to payments for salary, these distributions also avoid the self-employment tax. Of course, small business owners should always check with a tax advisor before assuming this will be the outcome under the particular circumstances.
In short, this alternative offers the ability to withdraw funds in a way that avoids both the self-employment tax and the onerous constructive fraud restrictions. The use of this type of debt funding ensures that assets contributed by owners to the entity will not be vulnerable to the claims of the business's creditors. Strategically funding the business entity with loans and leases using operating and holding companies is a significant asset protection strategy. Thus, the use of loans and leases should be a first-line withdrawal strategy.
Loan/lease tax Issues for the LLC
For the corporation, withdrawing funds as payments for loans and leases offers significant advantages and should ordinarily be a first-line choice for withdrawing funds. Generally, self-employment tax is avoided because the entity is not usually in the business of making loans and leases, so any funds from these transactions are not considered self-employment income.Overall, the asset protection advantages apply in the case of an limited liability company (LLC).
However, in the one-owner LLC, the self-employment tax advantage with respect to loans and leases is not as clear. While, essentially, the tax treatment of a one-owner LLC and a multi-owner LLC is identical, the tax classification in each situation is somewhat different. For tax purposes, a multi-owner LLC is classified as a partnership. (Note that this classification is only for tax purposes and does not affect the limited liability of the owners of the LLC). Thus, the multi-owner LLC files an information return with the IRS, which reports the LLC's income and the allocation of this income to the individual owners. The owners then report their share of the income on their personal income tax returns.
The multi-owner LLC should enjoy the same exact self-employment tax advantage with respect to payments for loans and leases that owners of a corporation enjoy. Thus, the payments should not be subject to the self-employment tax if the recipients are not in the regular business of extending loans or leasing property. In this case, owners would pay self-employment tax only on their share of LLC earnings, plus payments received for salary.
Further, funding an LLC with debts (i.e., loans and leases) offers distinct asset protection advantages. Thus, in the case of the multi-owner LLC, withdrawals as payments for loans and leases also should be a first-line strategy.
In the case of the one-owner LLC, the situation is somewhat less clear, because the one-owner LLC, technically, is classified as a "disregarded entity" for tax purposes, similar to a sole proprietorship. (Once again, this classification is only for tax purposes and does not affect the limited liability of the owner). Because the entity technically does not exist for tax purposes, it files no form at all with the IRS. The owner simply reports the LLC's income on his personal income tax return. This greatly simplifies the payment of income taxes and is consistent with the theme of simplicity that applies to LLCs.
However, this also means that payments by the LLC to the owner for loans and leases will not be recognized on the tax return, because for tax purposes the entity and the owner are one in the same. Due to this fact, these payments may not escape the self-employment tax. Conceivably, having the LLC make these payments to a separately owned LLC will fall to the same argument, as the other LLC also will be "disregarded" for tax purposes.
Of course, if even one other person (i.e., another family member) were an owner, irrespective of how nominal the ownership interest, then the LLC would be a multi-owner LLC and should come under the partnership version of the rules (absent the application of any aggregation rules, which might, for example, count all of the family's interests as one interest).
Conveying ownership interests to family members also can be a very effective estate planning, and thus asset protection, strategy. In short, qualifying the LLC as multi-owner may allow the LLC to avoid the self-employment tax with respect to payments for loans and leases. However, because this area of law is still currently developing, it is especially wise to check with a tax advisor to determine the self-employment tax consequences of particular withdrawal strategies in an LLC.