What are the tax Implications for an LLC vs S Corp?
For tax purposes, business entities come in two major flavors. There are “C corporations,” which are corporations that are subject to “double taxation” in that the companyʼs income is subject to tax, and its owners are subject to tax a second time on any distributions from the company to them. Many business owners choose not to use a C corporation because of this double level of tax. Instead, they opt for a “pass-through” entity; pass-through entities and their owners are subject to just a single level of tax. The entity itself does not pay tax but instead allocates its profits and losses to its owners, who then report that profit (or loss) on their own tax returns. There are two types of pass-through entities. The first is the “S corporation” and the second is the limited liability company (or “LLC”) that is taxed as a partnership. This article compares the two pass-through entities in order to help you be better informed when you talk to your lawyer and accountant about which business form is right for you.
Structure and Ownership
There are significant limitations on both the structure and ownership of an S corporation. An S corporation can only issue a single class of stock, which means that each share must be like every other when it comes to dividends, distributions and other economic rights. The only permissible difference is that some shares can have the right to vote and others can be non-voting. In addition, only U.S. citizens and residents, as well as certain trusts, can own S corporation stock. Another corporation, a partnership or an LLC cannot own any S corporation shares. In many cases, these two factors rule out using an S corporation to own a business.
On the other hand, LLC interests do not have to be confined to a single class. The LLC pie can be divided into an almost unlimited array of slices, each having different rights and preferences. This means it is possible to divide up the profits of the business in different ways. There are also no limitations on who can own interests in an LLC. It is thus a much more flexible entity than an S corporation.
There are a number of key tax issues that prospective business owners should consider when deciding between an S corporation and an LLC for their business venture. The list below is simply an overview and not a substitute for consultation with your lawyer and accountant. It is important to choose your form of business entity wisely, as a small amount of time and professional fees at the beginning can save you lots of time and professional fees down the road.
Contributing Appreciated Property to the Entity
Persons contributing appreciated property (such as real estate) to an S corporation in exchange for stock do not recognize taxable income on the exchange, provided that the person or persons making the contributions end up owning at least 80 percent of the S corporation. This test is usually easily met at the time a business is formed, although it can be more difficult down the road when a new shareholder wants to contribute appreciated property for stock. Contributions of appreciated property to an LLC, however, are generally tax free and there is no ownership or control requirement.
Compensating Employees with Equity
An employee or other service provider who is granted S corporation stock, or who exercises a non-statutory option to purchase S corporation stock, recognizes taxable income to the extent the fair market value of the stock exceeds the purchase price paid by the employee. It is also possible to grant incentive options to employees (but not other service providers); these options have favorable tax consequences but have strict limitations on the terms and conditions of the grant. On the other hand, it is possible, if one is careful, to structure ownership interests in LLCs that can be issued to employees and other service providers on a tax-free basis.
Basis in Ownership Interests
In both an S corporation and an LLC, the owners will have basis in their ownership interest equal to: (i) the amount of money or property contributed to the company, plus (ii) profits of the business that are allocated to them, less (iii) distributions of money or property, and less (iv) losses of the business that are allocated to them. Distributions of money (other than wages) are tax free to the extent of basis in both entities. There is one key difference, however. The debt incurred by an S corporation will not increase its shareholders’ basis in their S corporation stock, but the debt incurred by an LLC will increase its members’ basis in their membership interests. This means that debt can support tax-free distributions to the members, although this is not without consequences down the road.
A primary focus of many accountants and lawyers when choosing between S corporations and LLCs is selfemployment taxes. The self-employment tax is made up of two components. The first is old age, survivor and disability (OASDI), which is a 12.4 percent tax, and the second is hospital insurance (HI) which is a 2.9 percent tax. OASDI applies to the first $97,500 in self-employment earnings and HI applies to all self-employment earnings. (The OASDI cap adjusts every year and the figure given is for 2007.) In an S corporation, the self-employment tax applies to the salaries paid to the S corporation shareholders, but does not apply to profits allocated to the shareholders. This general rule, however, assumes that reasonable compensation is paid to the shareholders, and business owners should be aware that the IRS closely scrutinizes whether or not reasonable compensation is in fact being paid. In general, in an LLC the conservative position is that self-employment taxes apply to all profits allocated to a member who is active in the business, although the law is not entirely clear and different advisors can (and do) reasonably take different positions on this issue. Thus, the S corporation structure may save some selfemployment tax, particularly the HI portion (given the OASDI cap).
Dissolution and Distributions of Appreciated Property
When an LLC dissolves (i.e., winds up its business, pays its debts, and distributes its remaining assets to its members) in general the members only pay tax to the extent the value of cash and marketable securities exceeds their basis in their membership interests. Unlimited amounts of appreciated property (such as real estate) can be distributed to the members free of tax to either the LLC or the members. On the other hand, an S corporation recognizes taxable income when it distributes appreciated property to its members; this taxable income, like all other S corporation income, is then allocated to the shareholders and reported by them on their personal tax returns.
Estate and Gift Taxes
Although this article is primarily focused on income taxes, I would be remiss if I did not point out that if an LLC is appropriately structured and used as part of an overall estate plan, its owners can make equity transfers to family members and other beneficiaries on a more tax-efficient basis than can be done with S corporation stock.
As you can see from the above list, S corporations and LLCs have their own advantages and disadvantages. Generally, LLCs are a more flexible business entity in terms of taxes. This is also true in terms of other issues related to business ownership and operations, such as determining management structure, level of entity formality required, asset protection, etc. In general it has been my experience that an LLC is often the better choice of entity. That said, the choice is fact dependent and you should certainly consult your own advisors before choosing which entity best suits you and your business.