For New Businesses, What Are the Benefits of an LLC Over an S Corporation? You Have Six Choices For How Your LLC Is Taxed… Pick The Wrong One, And Your Profits May Take A Huge Hit! With the passing of the check-the-box-Regulations at the end of 1996, LLCs now can enjoy limited liability, centralized management, free transferability of interests and continuity of life, and still be taxed as a partnership Federally! LLC Taxed As An S Corporation: The Best Of Both Worlds? (The Odds Are You’ll Have The Wrong Operating Agreement!) Around the same time as the check-the-box regulations were being put in place S corporations rules were being revised. There were 17 statutory amendments enacted by Congress as part of the Small Business Job Protection Act of 1996. The Sub S amendments were intended to promote similarities between the S corporation and partnerships. For example, now S corporations can have up to 75 shareholders and an S corporation can own any percentage of stock in a C corporation (remember a C corporation, LLC or LP can not be the stockholder of the S corporation). That is why it is so hard to protect the S corporation stock). Example 1: It is ok for an S corporation to own Stock in a Corporation.   Example 2: It is NOT ok for an S corporation stockholder to be a C corporation Sec. 1361 (b)(1)(B). *A Term LLC will dissolve at a predetermined date, i.e. 30 years from the date of formation. An at-will LLC will dissolve under basic partnership rules. Because of these changes, we need to reanalysis the S corporation compared to a C corporation. Confusing? You Bet… But NCP Will Help You Sort It All Out. Call Us at 1-888-627-7007 for a FREE 30-Minute Consultation! Let’s examine the following areas of differences between S corporations and LLCs: State Law Differences Eligibility Limitations Multi-Tiered Structures Tax Rates Certainty of Tax Status Tax-Free Formation Issues Equity Interests Received For Services Entity-Level Taxation Use of Cash Methods Debt-Basis Issues Distributions Sales or Exchanges of Equity Interests State Law Differences A corporation C or S is organized under a governing state statue pursuant to its corporate charter. All corporations start out as C corporation then have to make an election within 75 days to become an S corporation, form 2553. The corporate charter generally requires the disclosure of the following: The corporation’s purpose Incorporators of the corporation Place of the registered agent Initial Board of Directors Classes of Stock Following the filling of the articles of incorporation, the Bylaws are adopted. Minutes and meetings are held and stock is then issued. Buy-sell agreements may then be put in place to handle the death of one of stockholder. A corporation has limited liability to its owners, has centralized management though the board of directors, and exists perpetually until it either becomes bankrupt or is liquidated and dissolved by the vote of a majority of its shareholders. An LLC is also a creature of the state. It has the best of both worlds of a corporation and a limited partnership. In the past you had to be careful not to have two or more of the corporate characteristics so you would be taxed as a partnership. Now, with the check-the-box rules you do not have to worry about that. So the LLC allows much more flexibility in its drafting. Much of this flexibility comes from the operating agreement. Despite this difference with an S corporation and LLC, the states basically provide the same limited liability for shareholders of an S corporation as with members of an LLC. Conclusion: State law should be considered a neutral factor in comparing multiple-member LLCs to S corporations. The single member LLC is recognized in 21 jurisdictions and may afford less protection from unlimited liability to its owners. In contrast, the single-shareholder S corporation still insures limited liability (this assumes the corporate veil will not be pierced. That is another advantage of Nevada because it is the most difficult state in the country in which to pierce the corporate veil). Eligibility Limitations There is no limitation on the number of investors who can participate in an LLC taxed as a partnership. The exception is a publicly traded partnership provisions under Section 7704, which recast a pass-through entity under state law into an "association" for federal income tax purposes. Even though 21 states allow single member LLCs, most states do not. A challenge comes about when you form an LLC in a state that allows one person LLCs and then you have to register to do business in a state that does not recognize one person LLCs. This is all despite the fact that the –box rules allows a single person LLC. Subchapter S corporations have always capped the number of stockholders to its present day number of 75. Spouses (and their estates) are considered to be one shareholder Sec. 1361 (C)(1). The next area to compare is who can be eligible to be equity participants. Since any individual or entity, foreign or domestic, can be a member of an LLC, the LLC has substantial advantages over the S corporation. The S corporations are subject to rigid rules as who can be owners. As we already mentioned, LLCs, corporations, LPs, and certain trusts can not be owners of S corporations. Only a grantor trust, qualified Subchapter S trust (QSST), or the new electing small business trust (ESBT). Now, let’s compare the limitations on use of debt/equity. Since S corporations only have one class of stock, LLCs have an advantage. An S corporation can not provide a liquidation or distribution preference to a shareholder. Even a buy-sell agreement must be carefully drafted as not to provide a second class of stock Reg. 1.1361-1(l). In other words you can not draft a buy-sell agreement to circumvent the single-class-of-stock requirement and the agreement establishes a redemption or purchase price which, at the time the agreement was entered into, was significantly below or in excess of the stock’s FMV Reg.1.1361-1(l)(2)(iii). This regulation basically says agreements to redeem or purchase stock upon the death, divorce, disability termination of employment are disregarded under the single-class-of-stock analysis. An S corporation can issue or enter into the following types of securities or arrangements without placing its pass-through status at risk: Qualified straight debt-Sec 1361 (c)(5). This basically means a debt that is written and unconditional obligation to pay a sum certain in money with interest rate and payments dates not conditioned on the borrower’s profits or discretion and which is not convertible directly or indirectly into stock. The holder must be an eligible shareholder; there are exceptions after 1996 on this. Nonvoting common stock- Sec 1361(c)(4). Equity-type arrangements not resulting in the issuance of stock, including options (other than "in-the-money"), phantom stock or stock appreciation rights-Reg. 1.1361-1(b)(4). A joint venture or other business arrangement with persons otherwise unable to own stock in the S corporation directly- Reg. 1.1361-1(l)(4)(ii)(A)(2). By contrast LLCs and partnerships can issue multiple classes of equity interests, create distribution and liquidation preferences, provide for special allocation of tax items (within the boundaries of Section 704), and issue equity-flavored debt. Multiple-Tiered Structures An LLC or LP can be itself a member or partner of other LLCs or LPs. Multiple tiered structures allow for protection against creditors and separation of business assets. A typical situation may look like this: Until the 1996 Act, S corporations were greatly disadvantaged in this area. For example an S corporation could not own 80% of the value of stock of another corporation. Now, the 1996 Act permits an S corporation to own any percentage of stock in a C corporation. These S corporations’ structures have limitations unlike C corporation’s structures. For example, dividends paid to the parent S corporation are ineligible for a dividends-received deduction and other transactions are excluded from the application of consolidated return rules. Tax Rates From a federal income tax standpoint, an LLC member who is an individual and the shareholders of S corporations are equally subject to the maximum marginal rate of 39.6%. By contrast, the maximum rate of federal income tax on a C corporation is 35%. Can you see how with an LLC there may be a tax advantage to have a C corporation as the member? There is however, a slight advantage for shareholders in S corporations in the employment tax area. The combination of FICA, FUTA and Medicare taxes for employee shareholders of an S corporation is 15.3% of the first $102,000 of wages-Rev.Rul. 59-221, 1959-1CB 225. By setting a reasonable salary, a shareholder of an S corporation can avoid paying the additional Medicare taxes of 2.9% on the distributive share of income from the S corporation. According to Sandy Botkin, he recommends taking a salary of about 50% of the S corporation’s net profits. So if the S corporation has net earnings of $100,000 at years end, $50,000 should be salary subject to payroll taxes. For partnerships it is different. Under Section 1402 (a), an individual partner’s net earnings form self employment, also taxed at a rate of 15.3%, includes the individual’s distributive share of partnership income (exceptions are for rental income, section 1402 (a)(1), interest and dividends Section 1402 (a)(2), and capital gains and losses 1402 (a)(3). What does this mean? If you have rental property or investments in an LLC that income will not flow though to you subject to self-employment taxes! Keep in mind a limited partner’s receipt of a guaranteed payment for services is within the self-employment tax base. The main question for an LLC is whether the member is a limited partner or not! Prop. Reg. 1.1402(a)-2 provides an investor in a pass-through entity, including an LLC, will be a limited partner for self-employment tax purposes unless such individual: Is personally liable for entity debts by reason of being a partner or member, Has authority to contract on behalf of the entity under state law or the governing instrument, or Participates for more than 500 hours during the tax year in the entity’s trade or business. So if you have the authority to bind the LLC, liable for the debt and work more than 500 hours per year you will be subject to SE taxes. SEE pages for more detail on SE taxes. Certainty of Tax Status Despite the reforms with the S corporations’ shareholders, great efforts must be followed to not lose the S status. Once lost, an S corporation can not re-elect S status for five years. In contrast with the check-the-box rules, the tax status of an LLC as a pass-through entity is simple to establish and maintain. The advantage clearly goes to the LLC in this category. Tax-Free Formation Issues Assets can be transferred to a corporation tax-free under Section 351 provided the transferors control the corporation. Section 368 (c) defines control for purposes of ownership to be at least 80%. So if you transfer an asset to an S corporation and you want it to be tax-free you must take back 80% of the stock. If you are transferring an asset that has a greater debt than basis (mortgage over basis), the excess above the basis will result in a taxable gain. Example: You have a rental property with a FMV of $150,000. It has a basis of $50,000 and a mortgage of $75,000. Under Sec. 351 you could transfer it to the S corporation. Since there is a mortgage over basis of $25,000, you would pay personal income tax on that $25,000. In an LLC, when you transfer assets tax-free into that falls under Section 721. These are the partnership rules for tax-free transfers. They are very similar to the corporation. Equity Interests Received for Services When a member of an LLC receives a membership interest in exchange for services, the transfer falls outside of Section 721. The value of the capital interest is treated as a guaranteed interest and is included in gross income. Section 707 (c) and Reg. 1.721-1(b)(2). This immediate taxation can be avoided if the members contribute property or capital to the LLC. It may be each member contributing as little as $500 for his or her interest in the LLC. In an S (and C) corporations, the receipt of stock for services is taxable to the recipient provided the stock is non forfeitable or transferable –Sections 83 (a) and 1032 (nonrecognition for exchange of a corporation’s own stock). A corresponding deduction is allowed to the corporation- Section 83 (h) and Reg. 1.83-6. Entity-Level Taxation The LLC is not subject to federal income tax unless it affirmatively elects to be taxed as an association. Also, single member LLCs are also ignored for federal income tax purposes unless the owner opts to be taxed as a corporation. Some states have a franchise tax on LLC income, most states do not. The LLCs tax year generally must conform to that of the majority in interest of its members- Section 706 (b). The tax year of an LLC will close on a termination or sale of 50% or more of the equity interests within a year. It will also close with respect to a withdrawing member who sells, exchanges, or liquidates his entire interest. The tax year of an S corporation may be closed in the event of the complete termination of a shareholder’s interest or where a certain percentage of its stock is sold over a certain period – Section 1377(a)(2); see also Reg. 1.1377-1(b). S corporations are generally not subject to corporate income taxes. The exceptions to non-entity level taxation are applicable to former C corporations that convert to S status. For example, under Section 1374 on net built-in-gains recognized during a ten-year post-C-to-S conversion period, there is a corporate tax imposed. Another example would be a C corporation converting to S status is required to recapture the LIFO-FIFO spread over a four-year period-Section 1363 d. The S corporation’s tax year generally must be a calendar year or one that is the same as its principle shareholders- Section 1378. Use of Cash Method Typically an LLC is not permitted to use the cash method of accounting- Sections 446 (c) and 448 (a). This is based upon the definition of "tax shelter" in Section461 (I) (3). The IRS however, issued several rulings permitting an LLC to use the cash method where; The LLC did not expect to generate losses, The members practiced in the profession in which the LLC was engaged, The LLC was not formed for a tax-avoidance purpose The interests in the LLC were not syndicated, and The equity partners managed the entity (see Ltr. Ruls. 9321047). The S corporation on the other hand has no limitation to the type of accounting method it chooses. An S corporation can not adopt the cash method if it is a "tax shelter". Of course, where inventories are used, the accrual method must be adopted unless the IRS permits otherwise- Reg. 1.4446-1(e)(1). Debt-Basis Issues A shareholder of an S corporation can increase his or her basis by the following ways: By the amount of funds or basis of property contributed to the capital of the corporation. By the amount of funds advanced to the corporation in the form of a loan- Section 1366(d). An S corporation shareholder can NOT add to stock basis any indirect contributions, such as the amount of corporate indebtedness, even if its repayment has been personally guaranteed by the shareholder, unless the guarantor has made an "actual economic outlay." Basically, did the shareholder have to put up some money or just a personal guarantee? Each shareholder of the S corporation is subject to the at-risk limitation rules under Section 465. This means that loss allocated to a shareholder may be deducted only to the extent that the shareholder is ‘at risk’ unless they are exempt from the ‘at risk’ rules. If there is losses in excess of what the shareholder has ‘at risk’ they are suspended and carried forward to the next year to be offset against income allocated to the shareholder at that time. Another limitation to shareholder losses is the passive activity loss rule of Section 469. C corporations are exempt from the passive activity rules. Each shareholder must determine to what extent they have participated in activity conducted by the corporation. Everyone would love to have passive income, because it is not subject to payroll taxes. Here are the tests to determine if an activity is active: The individual participates for more than 500 hours during the taxable year. The participation is the same as all the other participant during the year. The individual participates for more than 100 hours, but not less than any other individual. The activity is a ‘significant participation activity’ and the individual’s cumulative number of hours or participation exceeds 500 hours. The individual materially participated in the activity five of the ten years immediately preceding taxable years The individual is a service activity and the individual materially participates in any 3 preceding years. If you worked at something for less than 100 hours and someone else works 200 hours your income would be considered passive. This could be offset by your passive losses. Members in an LLC are permitted to increase basis in their interest for their allocable share of entity level debt in accordance with the Section 752 Regulations. This is not true for S corporations. Then we have to address the terms ‘recourse’ and ‘nonrecourse’ debt. If an LLC acquires a piece of property and subject to the existing debt (meaning no member has any liability for it) that would be called ‘nonrecourse’ debt to the LLC. The unique thing about nonrecourse debt is that it can be allocated to member’s basis disproportionately to their percentage of ownership. For example, if two people are members of an LLC 50/50. The LLC purchases a piece of property with debt without the members having to be liable for the debt. Let’s say the debt is $100,000, instead of distributing it $50,000 to each partner, you can distribute $20,000 to one partner and $80,000 to another partner! If an LLC purchased a property and each member personally guarantees the debt, then it is recourse debt to the LLC and its members. If in the above example the debt of $100,000 were recourse, then it would have to be split up 50/50. The ‘at-risk’ rules also apply to members of an LLC. Usually most debt of the LLC is nonrecourse. No member will be able to include it in basis for ‘at-risk’ purposes. There is an exception, an LLC member who personally guarantees a debt of the entity will be ‘at-risk’ where his S shareholder counterpart may not be (remember a personal guarantee does not increase basis in the shareholder of an S corporation). Also, if real estate is secured by nonrecourse debt, the LLC members can qualify for their share of the debt, under the ‘at-risk’ exception in Section 465 (b)(6)., which is not applicable to S shareholders. Distributions For an S corporation without earnings or profits, distributions are treated first as a nontaxable return of capital to the extent of the shareholder’s stock basis, and then as a gain from the sale or exchange of property (Code Sec. 1368(b), Reg. § 1.1368-1(c)). For a corporation with earnings and profits, unless an election is made, distributions are treated as follows: a nontaxable return of capital to the extent of the corporations "accumulated adjustments account" (AAA); dividends to the extent of the S corporation’s accumulated earnings and profits a nontaxable return of capital to the extent of the shareholder’s remaining stock basis, and gain from the sale or exchange of property (Code Sec. 1368(C), Reg. § 1.1368-1(d)). Before applying these rules, the shareholder’s remaining stock basis and the AAA are adjusted for the corporate items passed through from the corporate year during which the distributions are made. The accumulated adjustments account is used to compute the tax effect of distributions made by an S corporation with accumulated earnings and profits. If a C corporation converts to an S corporation, and if the distribution of corporate property has appreciated while it was in the C corporation, the built-in gain at the date of conversion will be subject to corporate-level tax under Section 1374. Distributions of loss property do not result in the recognition of loss. For LLCs, the tax treatment of distributions under Subchapter K will generally be more favorable than the results under Subchapter S, especially with respect to distributions of appreciated property! No gain or loss is recognized by the LLC for distributions of appreciated property. But with an S corporation the distribution will be taxable! If property is distributed within a five-year period of being contributed to the LLC there are some special rules- Section 737. This applies when a partner contributes appreciated property to a partnership and, within five years of the contribution, property is distributed back to the contributing partner. If the value of the distributed property exceeds the distributee’s basis in his partnership interest, and if the partner continues to hold the property, the distributee partner will recognize the gain equal to the lessor of: the excess of the value of the property distributed over the distributee’s partnership basis or the net precontribution gain of the distributee-partner in accordance with Section 704 (c) (1)(B). Cash distributions in excess of basis are taxable. The other main point is that any type of distribution in excess of your basis is taxable. The goal is to have a high basis in your LLC interest. This can be accomplished by adding debt to the LLC, which was mentioned earlier. Sales or Exchanges of Equity Interest When a shareholder of an S corporation sells part of all of his or her stock to a third party, the transaction generally will result in capital gain or loss. Unlike LLCs and partnerships, shareholders of S corporations are permitted to exchange shares of stock with other shareholders in one or more S or C corporations pursuant to the requirements of the tax free reorganization rules in Section 368. Where an LLC member sells or exchanges the interest in the LLC, gain or loss is determined under Section 741 and generally results in capital gain or loss. If an LLC sells the entire interest, the LLCs year will close on the date of the sale-Section 706 (C) (2)(A). Also, installment sale reporting is not available to the extent that the selling member’s share of any underlying assets of the LLC would be ineligible for installment reporting- Section 453 (I). Are You Subject to Self-Employment Taxes on Distributions at the End of the Year of an LLC? The Internal Revenue Code imposes a self-employment tax on a general partner’s distributive share of income from the partnership’s trade or business. Code Sec. 1401 and Code Sec. 1402. In contrast, the distributive share of a limited partner is generally excluded from the self-employment tax, except to the extent that this share is a "guaranteed payment" (Code Sec. 1402(a)(13). Pursuant to Code Sec. 707 (c), a "guaranteed payment" is an amount paid to a partner for services actually rendered to or on behalf of the partnership without regard to the income of the partnership. It is considered as made to one who is not a member of the partnership, and is thus subject to the self-employment tax). Limited partners are exempted from the self-employment tax rule under the theory that they are more passive investors than true partners are. In review, here is the general partner of the LLC (which would be the manager of the LLC or the member that resembles the characteristics of a general partner)’s tax situation; A general partner’s distributions are subject to self-employment taxes, and Guaranteed payments are subject to self-employment taxes. Here are the tax ramifications of a limited partner: Limited partners are exempt from self-employment taxes, and Guaranteed payments are subject to self-employment taxes. The IRS realized that the distinctions for general and limited partners worked fine for Limited Partnerships, but in the world of LLCs, the laws didn’t distinguish between the two. Something else had to be done. The IRS set new proposals for all entities taxed as Limited Partnerships. They now have a proposed legislation of the definition of a Limited Partner under Code Sec, 1402(a)(13), which may be made effective before July 1, 1998. Under the proposed regulation here is the definition of a limited partner: A limited partner would be any person classified as a partner unless they: Had personal liability for the debts or obligations of the partnership by reason of being a partner (called the liability test), Had authority to enter into contracts on behalf of the partnership (called the revised management test), OR Participated in the partnership’s trade or business more than that 500 hours annually (called the participation test). These so-called "functional tests" make it clear that the distributive share of non-managing members of an LLC will not be subject to SE (self-employment tax). Although many do not like this proposed expanded definition of a limited partner, the final result is right around the corner. The reason the expanded definition is largely unwelcome due to the concern it will cause for more record keeping as well as imposing new taxes on partners. Ready to Incorporate? Call NCP Today! 1-800-351-5111 And You Will Avoid Costly Mistakes! Notice: Concerning the above tax comments, keep the following in mind: This is how the above tax strategy works generally. This assumes that you are running a business with an honest "expectation of profit" and "that your expenses are ordinary, necessary, reasonable and directly related to your business." You document the deductions correctly.

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