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Organizing a Small Business – S Corporation or LLC

The S corporation was created by Congress in 1958 to provide a tax favorable business structure for small businesses, and for many years it was the almost universal choice for the organization small business companies. The more recent creation of the limited liability company (LLC) has made the choice more interesting because the LLC has become the preferred business organization for many small businesses, particularly businesses that are formed to own and operate real estate properties. This paper will discuss some of the considerations governing the choice.[1]

Both S corporations and LLCs provide the protection of limited liability for their members. Both are also pass-through entities under the Internal Revenue Code (the “Code”) that allow their members[2] to receive distributions of profit that are taxed only to the member, avoiding the entity level tax. However depending on the business in which the company is engaged and the manner in which the members desire to participate, choosing the most appropriate entity can be important.

If the company is engaged in a business that involves the ownership of real estate or will have investors who desire priority in the receipt of distributions, the LLC (or a corporation that has not elected to be taxed as an S corporation) will almost certainly be the preferred choice as the result of differences in the manner in which corporations and partnerships, including LLCs, are taxed under the Internal Revenue Code.

A member of either an LLC or an S corporation may receive tax deferred distributions only to the extent of the tax basis of his interest in the company. A member of a LLC may include in the tax basis of his interest his percentage share of any outstanding indebtedness of the company other than a loan from certain related parties. By comparison, member of an S corporation may not include third party indebtedness in his tax basis, only the amount of a loan or loans that he has made to the company from his own funds. Moreover, a member of an LLC can increase his basis by guarantying a third party loan. A member of an S corporation may not increase his basis in this manner. Therefore the LLC is more favorable for delivering operating profits to its members.

Property as well as cash may be distributed to members of an LLC without an entity level tax. Moreover, at the member level, there is no tax imposed on a distribution of property from an LLC to a member; instead the property is acquired by the member with a carryover tax basis. Subchapter S does not govern the taxation of distributions of property other than cash from the company at the corporate level.[3] Instead, any appreciation in the value of property owned by an S corporation is taxable as gain at the corporate level that is passed through to the member. Therefore, for example, if the company is organized with the expectation that it may deliver property to its members (such as a company organized to develop a subdivision and deliver the approved lots to its members), the LLC is the clear choice.

An LLC having a single owner is completely transparent for tax purposes. Thus, the single member LLC provides limited liability without the need to comply with either the corporate or partnership statute; instead the owner is taxed in the same manner as if he conducted the business directly as a proprietorship.

Also, the LLC offers greater flexibility in the organization of the company taxed as a partnership:[4]

Unlike an S corporation in which all members must have the same economic rights in proportion to their respective interests, the LLC offers the opportunity to allocate different economic rights among its members, including priority for receipt of distributions and the ability to have special allocations of income, gain and loss among the members.

The LLC also offers great flexibility in structuring the management of a company. Unless otherwise provided in its operating agreement, an LLC must be governed either by its managers or by its members. However, the operating agreement may be structured to provide different management structures such as those set forth in the corporation statutes.

The greater flexibility in structuring an LLC can be a disadvantage for organizing a small businesses as well as an advantage. With flexibility comes complexity. Subchapter K, which governs the taxation of partnerships, does not provide the specific structural requirements set forth in Subchapter S. Also, partnership statutes are filled with traps for the unwary, including default provisions that may be inappropriate for the business to be conducted. Therefore, greater expertise is required to organize a company as an LLC that is taxed as a partnership as opposed to a corporation, and the expense is almost certain to be greater as well. For example, the provisions of the Code governing the allocation of profit and loss of a partnership among its members are complex to the point of being mind-bending. Because all members of an S corporation must have equal rights with respect to profit and loss, varying only to the extent of unequal ownership interests in the business, the structure of an S corporation is necessarily fairly simple.

An additional benefit available to members of a small business company organized as an S corporation in which all or most of the members are active participants is the ability of an S corporation to distribute a portion of the income of the business as tax deferred distributions of profit, provided that the active members pay themselves reasonable salaries.[5] Under existing law, members of an LLC that are active in a business are subject to self-employment tax on the entire amount distributed to them. In 1997, the IRS issued proposed regulations that would provide some relief from this result, however Congress expressly forbade these regulations from taking effect before 1998, and the proposed regulations have never been finalized. Recently, the IRS issued a directive that expressly stated that members of a management company organized as an LLC were subject to self-employment tax on their entire compensation from the company.[6]

As described above, your author would virtually always organize a business that will own and operate real estate as an LLC. If the company to be formed will have passive investors who require priority of payment, the LLC is a possible choice although the C corporation may be a more likely choice. Despite the current popularity of the LLC, your author would generally prefer the S corporation for a small company where the owners are active in the management of the business because of its greater simplicity unless the owners desire the greater flexibility of the LLC.

An S corporation would not be an appropriate choice for a company that is expects to generate substantial passive income. If an S corporation has passive income that equals or exceeds 25 percent of its gross receipts for the taxable year, the excess passive income is taxed at the highest corporate rate, currently 35 percent. If the corporation has earnings and profits from a prior history as a C corporation or from a merger with a C corporation, its S election will terminate if it has excess passive income for three consecutive years.

Finally, it is important to check the state tax laws when making the choice. Some states do not recognize subchapter S or may not recognize some of it provisions. For example, Massachusetts recognizes Subchapter S but imposes an entity level tax on Subchapter S corporations that have total receipts in excess of $6 million.

 


[1] Under applicable regulations, an LLC may elect to be taxed as a corporation, including an S corporation; however, in the absence of an election, an LLC is taxed as a partnership if it has two or more members. Except as expressly stated, the discussion in this paper describes the attributes of LLCs that are taxed as partnerships.

[2] For simplicity, this paper will refer to the shareholders of an S corporation as members.

[3] Matters not specifically governed by Subchapter S are governed by Subchapter C, which governs the taxation of corporations that have not elected subchapter S.

[4] The management discussion in this paper is based on the Massachusetts Limited Liability Act, MGL chapter 156C. Your author believes that the comparison described in this paper is mostly an accurate comparison for the limited liability acts of other states as well.

[5] This benefit has commonly been abused by members of S corporations who take unreasonably small salaries to minimize their taxable income. The IRS has successfully challenged many of these efforts. (Pigs get fat, hogs get slaughtered.)

[6] CCA 201436049.

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