In our tax practice, the most frequently used entities for our family or closely-held business clients are limited liability companies (“LLCs”) and S corporations (“S Corps”). Both of these entities are similar in many areas and generally provide limited liability protection to their owners from the entities’ creditors. However, because these entities also differ in many ways, one entity is often a better choice for your business.
Ding…ding…ding…let the match up begin!
Round 1: Formation
LLC. Members generally may contribute assets in exchange for capital interests without incurring tax. However, a member may incur tax if (a) the member contributes encumbered assets (to the extent the member’s contributed liabilities allocated to the other members exceed such member’s tax basis in its contributed assets and its share of the LLC’s liabilities), (b) the LLC is an investment company, or (c) the contribution is a disguised sale. A member may also receive a profits interest in the LLC in exchange for services in a tax-free manner.
S Corp. Shareholders generally may contribute assets in exchange for stock in a controlled S Corp without incurring tax. However, a shareholder may incur tax if (a) the shareholder contributes encumbered assets (to the extent the shareholder’s contributed liabilities exceed the shareholder’s tax basis in its contributed assets), or (b) the S Corp is an investment corporation. Unlike an LLC, a shareholder may not receive additional stock in exchange for services in a tax-free manner.
Match Up: In general, with proper planning, owners may form either entity without triggering tax. In addition, with proper planning, either entity may receive publicly-traded securities and cash without triggering tax. When encumbered assets are contributed that trigger tax, an owner may incur less tax on formation with an LLC. Owners, who will provide services and want a greater share of the profits (in excess of what their capital contributions justify), may prefer using the LLC since the profits interest may be received without immediate tax.
Round 2: Owners & Classes of Interests
LLC. An LLC has no restrictions on the number or type of owners. Various classes of ownership interests with different voting, distribution and liquidation rights are permitted.
S Corp. Owners generally may not include corporations, partnerships, LLCs and some trusts, but may include individuals and revocable trusts (as used for estate planning). Voting and nonvoting common stock is permitted, but all common stock must otherwise have the same distribution, liquidation and other economic rights. Preferred stock is not permissible.
Match Up: LLCs provide more flexibility in terms of permitted owners and types of ownership interests. However, if individuals and revocable trusts will be the only owners and want one class of ownership (or only voting and nonvoting interests/stock), either entity generally should suffice.
Round 3: One Level of Tax
LLC. Unless a special election is made, an LLC should be taxed as a flow-through partnership. Accordingly, while an LLC (with more than one owner) will file an annual partnership federal income tax return (Form 1065), the LLC will not pay income tax. Instead, the LLC’s items of income, gain, loss and deduction generally will flow through to its members in proportion to their respective interests and will be taxed on the members’ respective income tax returns. With proper planning, the members may make special allocations of various items of profit and loss to the members in different percentages and do not need to share proportionately in each item.
S Corp. The S Corp is also generally a flow-through entity that files an annual federal income tax return (Form 1120S); however, if the S Corp was previously a C corporation, there may be an additional tax on built-in gains existing at the time of the conversion. The shareholders pay tax on their proportionate share of the net pass-through items allocated to them from the S Corp. The shareholders must share proportionately in each pass-through item and no special allocations may be made.
Match Up: Both entities generally offer one level of tax to their owners, but only the LLC allows special allocations of income, gain, loss or deduction among the owners.
Round 4: Distributions
LLC. When the LLC distributes assets to its members, the members generally will not be taxed on the distributions. However, a member may incur tax if (a) the member receives cash or marketable securities and the value of such assets exceeds the member’s tax basis in its LLC interest, or (b) the member is relieved of debt in an amount that exceeds the member’s tax basis in its LLC interest. If a member receives a distribution of assets (other than cash or marketable securities), the distribution generally will not trigger tax.
S Corp. An S Corp’s distributions to its shareholders are generally nontaxable to the extent of the respective shareholders’ tax basis in their stock. However, if the S Corp distributes an asset to a shareholder, the distribution will trigger taxable gain to the extent the fair market value of the asset exceeds its tax basis.
Match Up: When distributing assets to owners, the LLC may result in less taxes. However, most ordinary distributions of cash from both of these entities to their owners will be tax-free since the owners already paid tax on their share of the flow-through items.
Round 5: Employment Taxes
LLC. Generally, members who actively perform services are subject to employment tax on their entire share of the LLC’s net income. However, if an LLC is engaged in a rental business, a member’s share of the net rental income generally is not subject to employment tax. For example, if an LLC (a service business) allocated net income of $110,000 to a member, the member would incur the following federal taxes: (a) income tax of $27,500 (assuming a 25% rate), (b) social security tax of $12,648 (12.4% on income up to $102,000 wage base in 2008), and (c) Medicare tax of $3,190 (2.9% on all income). The member would be left with $66,662.
S Corp. Shareholders are only subject to employment tax on their compensation but not on distributions. However, a shareholder’s compensation must not be unreasonably low; otherwise, some of the shareholder’s distributions may be recharacterized as disguised compensation. To demonstrate, if an S Corp (a service business) paid $50,000 to a shareholder as compensation and $60,000 as a distribution ($110,000 total), the following federal taxes would be imposed: (a) income tax of $12,500 (assuming a 25% rate) on the compensation and $15,000 on the distribution; (b) social security tax of $6,200 (12.4% on the compensation), and (c) Medicare tax of $1,450 (2.9% on the compensation). The shareholder would be left with $74,850.
Match Up: An S Corp may be a good choice when the owners are concerned about employment taxes. However, if an owner’s compensation is already above the wage base from other sources, the main difference between the LLC and the S Corp (on income taxed as compensation) will be the Medicare tax (2.9%). In addition, more complex tax planning may be done with multiple entities (LLCs, S Corps or limited partnerships) to help minimize employment tax issues while utilizing the benefits of LLCs/ limited partnerships.
Round 6: Losses & Tax Basis
LLC. A member may deduct its share of the losses up to the member’s tax basis in its LLC interest, subject to at-risk and passive activity loss limitations. The member’s tax basis in its LLC interest generally equals (a) the member’s tax basis in its contributed assets, less (b) the member’s contributed liabilities assumed by the LLC, plus (c) the member’s share of the LLC’s liabilities, plus (d) the member’s allocations of income, less (e) the member’s allocations of losses, and less (f) the fair market value of assets and cash distributed to the member.
S Corp. A shareholder may deduct its share of the losses up to the shareholder’s tax basis in its stock, subject to at-risk and passive activity loss limitations. The shareholder’s tax basis in its stock generally equals (a) the shareholder’s tax basis in its contributed assets, less (b) the shareholder’s contributed liabilities assumed by the S Corp, plus (c) debt that the S Corp owes to the shareholder, plus (d) the shareholder’s distributive share of income, less (e) the shareholder’s distributive share of losses, and less (f) the fair market value of assets and cash distributed to the shareholder. A shareholder’s basis does not include any part of debt that the S Corp owes to third parties or other shareholders.
Match Up: If the owners anticipate initial losses and the entity will have third party debt, the owners may be able to deduct more losses with the LLC; however, if minimal losses are expected or the owners have a high tax basis in their interests/stock, either entity may work.
Round 7: Death of Owner
LLC. Upon the death of an individual member, the deceased member’s interest takes a step-up in basis equal to fair market value. As a result, the LLC may make an election (the 754 election) in which the LLC’s assets related to the deceased member’s interest may also receive a step-up in basis to the extent of the fair market value of the decedent’s interest. A 754 election may also be made when a member sells or transfers its LLC interest during life.
S Corp. Upon the death of an individual shareholder, although the deceased shareholder’s stock takes a step-up in basis to fair market value, the successor shareholder will not receive a step-up in basis in any of its share of the S Corp’s assets.
Match Up: With the 754 election, a successor owner in an LLC will likely have less capital gains tax on the sale of the LLC’s assets as a result of the step-up.
- If you plan to start a rental real estate business and want a step-up in basis in your LLC interest (and the related real estate) at death, an LLC is usually the best choice. Generally, an S Corp should not hold real estate or highly appreciating investments.
- If you are forming a service business and want to minimize your employment taxes, an S Corp may be the better choice.
- If you anticipate losses in the first years of your business and want to deduct the maximum amount of losses, or if you want to use special allocations of tax items, an LLC may be a good choice. As your business later becomes profitable, an LLC may generally
- be converted to an S Corp on a tax-free basis (unless the LLC’s debt exceeds its tax basis in its assets), whereas the conversion of an S Corp to an LLC is a taxable event.
- If you own farm land and want to operate your business out of an entity for liability protection and business reasons, and want to start making gifts to your descendants while still maintaining control over most business decisions, an LLC is the better choice.
- If your business operates in several states, a more complex business structure utilizing multiple types of entities (LLC, S Corp and/or limited partnership) may produce the best income tax result.