Structuring the Business: S Corporation or LLC?

Overview

One of the common questions that we receive involves how to structure the business.  Traditionally, entity choice involved selecting from a sole proprietorship, partnership or corporation.  Beginning in the 1960s, however, the S corporation election became available to allow the pass-through of income and loss to the shareholders.  In the late 1970s the LLC concept emerged in Wyoming as a means of assisting the oil industry by giving their business enterprises partnership tax treatment with the limited liability feature of a corporation.  When the IRS later blessed partnership tax treatment of an LLC,[1] every other state passed legislation that allowed for the creation of LLCs.  In addition, an LLC can select its tax treatment, and if no election is made, certain default rules apply.[2]       

There are several things to consider when deciding to form either an S corporation or an LLC.   

The LLC as a Partnership

The default classification of a multi-member LLC for federal tax purposes is as a partnership, since the IRC does not recognize the LLC as a separate entity.  Taxation as a partnership provides the most flexibility of any entity.  On that point, consider the following:

• Upon contribution of assets to a partnership, generally no gain or loss is recognized and the basis of the contributed assets, less any debt relief that may occur upon contribution, becomes the member’s basis in the member’s interest in the entity.

• The allocation of income and losses is accomplished either through the operating agreement or by written or unwritten agreement of the members. However, the allocations must be in proportion to each partner’s interest in the LLC, or they must have “substantial economic effect.”[3]  

• A member is not an employee of the LLC.  Thus, any payments to a member are not subject to payroll taxes or withholding.  

• An LLC member could be either a general partner or a limited partner.  Several years ago, the IRS issued proposed regulations (which the Congress barred the IRS from finalizing) that provided guidance on the matter.  Under the proposed regulations, an LLC member is treated as a limited partner unless the member:  (1) has authority to contract on behalf of the company; (2) participates in the trade or business for more than 500 hours during the year; or (3) the LLC provides services as a trade or business in such fields as law, engineering, accounting, or consulting, in which case the contribution of even minimal services through the entity will result in self-employment tax liability.[4]

• Any deduction for pass-through losses is limited to the member’s basis in their interest and may also be subject to “at-risk” and passive loss limits.

• Distributions generally result in no gain or loss, but there are exceptions that apply, including distributions that exceed the member’s basis or are of recently contributed property or are made to a retiring partner.  Other exceptions to the no gain or loss rule apply to distributions that are of marketable securities or are of an interest in unrealized receivables or substantially appreciated inventory.

The LLC as a C Corporation

Granted, very few LLCs choose to be taxed as a C corporation.  That’s because doing so would trigger the “double taxation” issues associated with C corporations.   But, if the payment of fringe benefits is desired, or the lower corporate tax rates (compared to individual rates) could apply, then the C taxation option might be utilized. 

The LLC as a Disregarded Entity

The default classification of a single member LLC is that of a disregarded entity.   That means that if the sole owner is an individual, all items of income and expense will be reported on the appropriate Schedules (C, E or F) of that individual’s income tax return.  For single owners that are estates, trusts, partnerships or corporations, income and expense items are reported on that entity’s appropriate tax return.[5]  

Note:   A single-member LLC can be used to shield the owner from potential liability stemming from property ownership, employee negligence, and other risks associated with the business.  It will not, however, protect the owner from damages/injuries caused by the owner’s negligent acts.

While a single-member LLC eliminates many of the formalities and disadvantages associated with using a corporation, state law must be followed to ensure its legal status.  If those statutory requirements are not followed, “veil piercing” could result.

From a tax standpoint, with a single-member LLC, income and losses pass through as self-employment income.  While family members can be employed and provided with fringe benefits, fringes are generally not available for other employees.  Also, while transactions between the single-member and the LLC may be disregarded for federal tax purposes, there could be state statutory requirements that may treat such transactions differently.  This issue can come into play if, for example, the single-member enters into rental arrangements, sales or loans with the LLC. 

The LLC As An S Corporation

Election requirements. 

Self-employment tax. 

Typically, the reason for electing S status concerns self-employment tax.  S corporation officers/shareholders who provide more than minor services to the corporation and receive, or are entitled to receive, compensation are subject to self-employment tax.  The payments are treated as wages.  Non-wage compensation in the form of dividends or distributions could still be treated as wages if “reasonable compensation” is not paid in the form of wages.  This is a heavily litigated issue by the IRS with respect to S corporations.  An attempt to minimize self-employment taxable income by minimizing salary in return for higher amounts of non-self-employment taxable dividend distributions is an audit issue with the IRS.  The shareholder/employee must be reasonably compensated in the form of self-employment taxable wages for services performed for the corporation.  But, beyond the requirement to pay reasonable compensation, the S classification provides a means for extracting money out of the business without paying employment taxes - there isn't any employment tax on distributions (dividends) from the S corporation. 

Other tax issues. 

As noted above, a shareholder’s basis in their interest in the entity may limit deductibility of losses passing through.  In an LLC taxed as an S corporation, shareholders may have both stock and debt basis, with the LLC member’s equity in the LLC deemed to be a capital or stock interest. That basis may have been acquired by property transferred into the entity, or by purchase of the LLC interest.  If the LLC interest was purchases, its cost is the initial basis.[6]

Conclusion

Many factors influence the choice of business structure, and there is no “one size fits all” solution.  Both the S corporation and the LLC are popular business entity choices.  But, they have unique differences.  Depending on the particular situation and the goals and objectives of the parties involved, one structure may be preferred over the other. 

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