With farm income soaring, some farmers are looking for ways to reduce their taxes. One question I’ve been asked is if it’s a good idea to switch a farm partnership to an S Corporation (S Corp) to avoid self-employment tax. This is a good question but not one that is black and white. Let’s take a look at the differences between a partnership and an S Corp.
One big difference between a partnership and an S Corp is the way an owner gets paid. In a partnership, the owner recognizes income on his or her personal tax return. In order to take money out, they “distribute” funds. The distribution is typically tax-free unless their basis goes negative.
In an S Corp, the owners get paid a reasonable wage and issued a W-2. Unlike a partnership, where all income would be subject to self-employment tax, only the wages are subject to FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act). This could provide considerable tax savings.
S Corp owners can take additional money out as a distribution. There are ordering rules that govern the taxability of distributions. If there is basis in the S Corp, distributions up to the basis are tax-free. If additional money is distributed, it would be treated as a taxable dividend to the extent of the accumulated adjustments account (AAA), thereafter treated as capital gains income. Keep in mind this is under current tax laws.
Another difference between a partnership and an S Corp is the ability to have multiple classes of ownership interest. In a partnership, you can have multiple classes of ownership interest with varying economic rights. For example, I’ve seen where the parents own 75% of a farming partnership, but the kids do most of the work. To compensate the kids, the parents only take 25% and give the kids 75% of the profits.
Partnerships also allow for the transition of ownership through profit interests. In an S Corp, all stock must have the same economic rights. All taxable income is split based on ownership percentage; likewise, distributions out of the S Corp must be proportional to ownership percentage.
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One difference between S Corps and partnerships that has a substantial impact on farms is the use of debt.
In an S Corp, an owner can only get debt basis by borrowing money directly from the entity. Loan guarantees (recourse debt) do not provide basis.
In a partnership, recourse debt can provide debt basis. Why is that important in farming? Many farms overdepreciate assets and use debt to finance living expenses. This results in owners not having basis in the entity. In order to take losses or have nontax distributions, they rely on debt basis.
In an S Corp, debt basis might not be available, resulting in losses that are suspended or distributions that become taxable.
As you can see, chasing tax savings might result in bigger issues. Before switching from a partnership to an S-Corp, review the pros/cons.
Many times the lack of flexibility far outweighs the self-employment tax savings.
DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Read Rod’s “Ask the Taxman” column here. You may email Rod at email@example.com