Employee vs. Non-Employee LLC and S-Corp Planning for Mariners and their families

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by on January 10, 2011 at 8:12 pm

I’ve been a client of yours for a few years now and I had a general tax question concerning my wife’s job status. She currently works full time for a marketing firm in “Deleted”. She intends to cut back to a part time status where she can pick and choose which projects to work on. Some people in her field create their own “small business” if they are contracting out their services. She has the option to stay on her company’s payroll or to create herself into this “business.” I don’t know what the pros and cons are to this move tax wise. We are currently living in the “deleted” Area and I am still going to sea. If you could give me a little advice I would really appreciate it.

To LLC or not to LLC… That is the question… Or is it?

First off – like political economic theory – this is not an exact science. It’s very important to examine your specific facts and circumstances before entering into this type of arrangement. I’ll give some general terms, and then some pros and cons associated with different options.

Maritime Employee

Simply stated – an employee is someone under the direction and control of another. In the US, individuals who are employees receive their tax info on W-2′s. Mariners are generally under the direction and control of another. Absolute direction and control. A harbor pilot meeting a vessel would NOT be considered an employee of the vessel they are meeting. Depending on the State of operation, they may be considered an employee of the pilots association.

Employee Benefits for Merchant Seamen and their families

As an employee, you receive certain benefits from your employer

  1. Social Security/Medicare – Your employer pays half of this for you
  2. Unemployment – Your employer pays this with you as the beneficiary. If you’re laid off and meet requirements, you’ll be able to collect
  3. Medical – Your employer may cover some or all of your medical insurance. They may also offer a flexible spending account
  4. Child Care – Your employer may provide child care at its’ location. They may also offer a FSA dependent account
  5. Retirement – Your employer may match your retirement contributions to a certain percentage
  6. Vacation – Your employer may provide paid vacation time
  7. Sick Leave – Your employer may provide paid sick leave
  8. Organization – Your employer manages all of the aforementioned benefits with little to no input from you

The list is not all inclusive. But it does provide most of the top benefits

Mariners as non-employees

As previously stated, it is nearly impossible for a merchant seaman to qualify as a non-employee. But mariners often have spouses who are engaged in other business activities. Maritime professionals also transition to shore side and consulting positions. In these cases they may be considered non-employees.

Baseline Non-Employees

A classic non-employee example is a real estate broker. Although they work out of a general office, they are responsible for acquiring and maintaining their own book of business. They are not issued a W-2, but rather a 1099-Misc that reports non-employee compensation. This individual will generally file a Schedule C with their income tax return.

Schedule C Benefits

A schedule C is essentially an accounting of self employment for the tax year in question. All income from the business is reported up top. Deductions are taken as offsets against income. The big benefit is these deductions are taken “above the line”. Meaning they are not subject to most of the restrictions associated with the deduction of employee business expenses. These expenses are taken before 2% limitations and AMT items.

Child Tax Credit – The child tax credit begins to phase out on your tax return at $110,000. It’s a $1,000 cash credit that offsets your tax due (much better than a deduction). If husband earned $65,000 on a W-2 and wife earned $65,000 on a W-2 a single child tax credit would be lost regardless of employee business expenses. If wife was an independent contractor and filed a Schedule C with $20,000 in deductions the child tax credit would remain entirely intact.

Con – There’s always cons :) The biggest negative would be the self employment tax. Independent contractors are responsible for the entire Social Security/Medicare Tax (approximately 15%) on their net (after deductions). Employees are only responsible for half of that amount. So in this example, she’d be looking at a self employment tax of $6,750 vs employee withholding of $4,875. So if we were only examining the child tax credit advantage we’d realize that the self employment tax penalty outweighs the child tax credit benefit.

Summary – if we through in education credit limitations, AMT factors, and other income restrictive phase outs and limitations, self employment may take the lead. Factors to weigh in -

  • What level of deductions are associated with the business? The more legitimate deductions, the higher the self employment benefit. If there were little to no deductions, it is most likely beneficial to be an employee
  • What benefits are you losing. If you provide the health insurance, this is a huge factor. You’ll be losing that 401(k) match as well

Becoming a Corporation or LLC

First off, the primary purpose for incorporating or forming an LLC is for liability limitation. A properly operated entity is liable for the assets within that entity (you couldn’t lose your residence that was outside of the entity). Briefly stated, it is important to maintain ANY business so it can cover generally accepted costs and risks. An LLC without proper insurance coverage will probably be disregarded if there will legal issues. Professionals (doctors, lawyers, accountants etc…) are not protected by the corporate shield. They should be especially cautious and maintain e+o, or malpractice insurance policies.

The C-Corporation

Without going in depth – unless you plan on going public, don’t start out as a C-Corporation. C-Corps are self taxed entities. They file a separate income tax return and pay their taxes as a corporation. There are several pitfalls associated with C-Corps

  • Double Taxation – C-Corp net profits are considered dividends and have to be claimed as income by the shareholders. It’s possible for the high end effective tax on a C-Corp to approach 50% in Massachusetts
  • Distributing assets – Pulling assets out of a C-Corp can cause a taxable event
  • Built in Gains – Attempting to change to another entity after operating as a C-Corp for some time may subject you to an additional built in gains tax

Not an inclusive list – but it brings the point across.

S-Corporations

An S-Corp is essentially a C-Corp that elected to be treated as a pass through entity (conduit). A tax return very similar to the C-Corps is prepared and filed. The big difference is that the Corporation does not pay the tax (though many States impose excise taxes on S-Corps and Partnerships). The corporation issues K-1′s to the shareholders and the shareholders report the income on their tax returns.

Benefits

  • The corporate profit is not subject to employment or self employment taxes. You are an employee of your corporation. You file a W-2 and make payroll taxes as an employer. Your salary is (fair and reasonable) in your line of business. The remaining net profit is not subject to sting taxes.
  • The entity is by definition NOT an employee – more and more States are cracking down on companies referring to someone as a non-employee when they are in fact an employee. A corporation cannot be an individual.
  • Expense and benefit accounts – you’re probably able to create certain medical and benefit plans up through your corporation
  • Deductions – There is no AGI when it comes to a Corporation

You down with LLC’s…

An LLC, is NOT a tax entity. An LLC is a LEGAL entity. Advantage -

  • Easier to form and maintain when compared to a corporation

Single member LLC

If one person owns an LLC and takes no additional action they’re a Sole Proprietor (Schedule C) by default. There would be no additional advantage from a tax standpoint when compared to a non-entity Sole Proprietor.

Multiple member LLC

If more than one person form an LLC and take no additional action they’re a partnership (Form 1065) by default. Advantage -

  • Because of the Limited Liability Aspect the Courts consider net partnership income derived to not be subject to Sting taxes
  • It is easier to maintain payroll on small partnerships when compared to an S-Corp
  • Operational standards are not as complex as an S-Corp

The partnership will require a managing partner. The managing partner is subject to self employment tax on all partnership income. The MP doesn’t receive a W-2. Their salary is paid in the form of a guaranteed payment which is indicated on their K-1 (conduit reporting document).

Issue

The Courts have generally dismissed husband/wife LLC partnerships. (Husband has 1%material interest Wife has 99% passive interest). It’s set up this way to circumvent the sting tax. When this is questioned, they have been deemed a sole proprietor for tax purposes (all income subject to sting taxes).

Other LLC Formations

It is possible to be an LLC treated as an S-Corp or C-Corp as well. This way you could have the ease of operation coupled with additional reporting advantages associated with different entities.

What’s the catch?

  1. Complexity – the more complicated your entity, the more involved it will be to maintain it
  2. Cost – all of these things cost money. In Massachusetts LLC filing fees will run $500 annually. If you were to be an LLC treated as an S-Corp that number would be closer to $1,000

Back to the original question…

  1. If you’re dropping down to part time status, will you still be retaining any benefits?
  2. Is your employer offering a financial offset for your becoming a non-employee? Keep in mind that your employer will be saving about $1,000 on every $10,000 they pay you as a non employee.

Solely from a tax perspective

I generally advocate entity inception when net income passes $70,000 or so. This is the point that you generally begin to see a tax swing in your favor (but every case is different).

Some employers REQUIRE non-employees to be a Corporation or LLC. This has become more of a standard as States have been cracking down on bogus independent contractors. In my practice I generally advocate S-Corps over LLC’s.

The bottom line is there are many factors to take into consideration. At 70-100k entities begin to look a lot nicer. If we’re solely contemplating non-employee compensation be sure to factor in all of the related variables.

For Example – Full time salary (40 hr week) of $50,000 – It would be incorrect to simply figure $24/hour ($50,000/52 weeks/40 hours). You actually have 7.5% in withholding savings to the employer ($3,750), your 401(k) match ($3,000), 80% medical insurance coverage ($8,500), 2 weeks vacation, and one week sick pay.

This changes our hourly rate to $33/hour (50,000+3,750+3,000+8,500/49 weeks “subtracting vaca and sick”/40 hours). The employer will actually still be saving at this rate (this is why temp agencies bill out at $35-$50/hour). This is a fair method to determine a baseline for consultant compensation.

But I know someone who doesn’t pay taxes because they’re an LLC…

It’s called evasion… Just because someone is getting away with something doesn’t make it legal. There are advantages associated with these entities as outlined. By they certainly do not eliminate the income tax.



2 Comments

  • Patrick M

    10/01/2011

    I have friends who work for foreign companies. They have become S-Corps and say it saves them a ton on taxes…

  • Jim

    10/01/2011

    This is an interesting one. If your friend “works” for foreign companies, they may well be employed. Meaning They might not have to be making those payroll taxes every month… This has been an ongoing issue with several companies.

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