LLC vs S-CORP's - Stop Searching & Asking, Start Reading Here

[Vincent Incopero]

ENTITY INSANITY

THE REAL DIFFERENCES BETWEEN LLC'S & S-CORPORATIONS

So you’ve decided it’s time to start a business, Congratulations! You’ve know realized/learned that conducting business without the blessing of limited liability from your State Government is almost like willingly placing your hand in a running garbage disposal (+1). You are down to deciding between a Corporation and a Limited Liability Company (+2). (Remember, its Corporation and Company; not Corporation and Corporation)

You're looking at the costs associated with organizing both. You think to yourself "a Limited Liability Company must be better because (besides sounding more svelte) it costs more to start and EVERYONE has an LLC or is creating an LLC." You've googled and researched, blogged and replied, but the search results are confusing and the suggestions of your colleagues and fellow entrepreneurs are as consistent as they are divergent. You've even asked your bookkeeper/accountant just to get a second opinion, because after all "an accountant has to know the difference if they deal with these things every year." Unfortunately, most licensed professionals SPECIALIZE IN ONE DISCIPLINE, for a couple of good reasons, namely:

• 1.The old adage, jack of all trades, master of none; AND MORE IMPORTANTLY
• 2.Knowing just enough to get by has the potential to be really, really (YES REALLY) dangerous.

Fortunately, I’ve taken the time to scholarly myth-bust all of the claims, and settle all of the uncertainty, surrounding this Chicken and Egg scenario/debacle.

After reading this article, kindly ask yourself one question before you make your next move, namely, will you get this level of detail and knowledge from Legledoom.com? I think the answer is as clear as it is simple – You get what you pay for. When I’m not feeling good, I don’t go to MebWD.com to self-diagnose (and I hate going to the doctor’s office). Legledoom.com is about as similar to an actual Lawyer as MebWD is to the care and medical certainty of a Doctor.

Lastly, now that I've fully lost your attention, I'd like to mention that this article does discuss the distinctions of a Series LLC. Simply put, a Series LLC is an LLC which is made up of smaller LLC's (Series). A Series LLC has its advantages for certain industries/businesses and, to my knowledge, always costs more that the vanilla LLC discussed in this article. Those interested in learning more about the Series LLC are encouraged to research or consult an Attorney regarding the appropriateness of this type of LLC for your current or contemplated business endeavors. Finally, please note that THAT THIS ARTICLE IS NEITHER OFFERING TAX ADVICE NOR SHOULD IT BE INTERPRETED AS A SUBSTITUTE FOR A CONSULTATION WITH A LICENSED, CERTIFIED PUBLIC ACCOUNTANT.

The limited liability company ("LLC") is the newest entity candidate. LLC's came into existence in or about 1977, whereas Corporations were recognized under ancient Roman Law. Many claim that the LLC is the ultimate entity, arguing that it offers the best advantages of both Corporations and partnerships and few of the disadvantages. It's an overstatement, but not by much in some situations. There is no question that the arrival of the LLC has made the choice of entity challenge easier in many cases. Like a Corporation, the LLC is an entity organized under state law. As with a Corporation, it offers liability protection to all owners, making it possible for its owners to fully participate in the management of the business without subjecting themselves to personal exposure to the liabilities of the business. LLC's are classified as either member-managed (managed by all members) or manager-managed (managed by designated managers).

Although similar to a Corporation for state law purposes, a LLC is taxed as a partnership for federal income tax purposes unless it elects otherwise. As such, it offers better pass-through benefits than an S Corporation ("S Corp") and completely avoids all the S Corp eligibility and election hassles. An LLC can have more than 100 owners and partnerships, corporations, nonresident aliens, and any kind of trust can be included as owners. For these reasons, many wrongfully conclude that the LLC eliminates the need to consider S Corps and partnerships as viable pass-through entity candidates. There are still many situations where an S Corp or a partnership will be the entity of choice.

Although taxed as a pass-through entity, an S Corp offers a few of the same tax perks as C Corps (“C Corp”) that are not available to partnerships. An S Corp may enjoy all the benefits of the tax-free reorganization, and, except for collectibles, the capital gains benefit realized from the sale or exchange of S Corp stock is not watered down by ordinary income assets owned by the S Corp. An S Corp may even have a multi-entity structure that offers benefits comparable to the C Corp consolidated return perk.

The income of an S Corp is passed through and taxed to its owners, much the same as a partnership. The entity itself pays no tax on the income, and the shareholders' recognition of the income is not affected by the Corporation's retention or distribution of the income. This eliminates the C Corp double tax trap. Also, like a partnership, the income passing through an S Corp may qualify as passive income for those shareholders who are not deemed "material participants."

An S Corp's losses also are passed through to its owners, subject to the same three loss hurdles applicable to partnerships. The big difference is that the first hurdle, the basis hurdle, is much tougher in the context of an S Corp. The reason is that the basis calculation considers only amounts that an S Corp shareholder actually pays out-of-pocket (for stockpurchases and loans to the entity). There is nothing comparable to the generous liability basis allocation provisions applicable to partnerships.

The tax consequences of distributing money or property from an S Corp are generally much less severe than for a C Corp. Distributions of S Corp income are tax-free to the shareholders. The popularity of the S Corp status is attributable to three factors:

(1) Accumulated earnings increase the outside stock basis of the shareholders' stock;

(2) An S Corp is free of any threat of a double tax on shareholder distributions or sale and liquidation proceeds; and

(3) S status can facilitate income shifting and passive income generation.

There are certain limitations and restrictions with an S Corp that can pose serious problems in the planning process. Not every Corporation is eligible to make an S Status election. If a Corporation has a shareholder that is a Corporation, a partnership, a non-resident alien or an ineligible trust, S status is not available. Also, the election cannot be made if the Corporation has more than 100 shareholders or has more than one class of stock. The one class of stock requirement is not violated if the corporation has both voting and nonvoting common stock and the only difference is voting rights.

Electing in and out of S Corp status can present some planning challenges. An election to S status requires the consent of all shareholders. A single dissenter can hold up the show. For this reason, often it is advisable to include in an organizational agreement among all the owners (typically a shareholder agreement) a provision that requires all owners to consent to an S election if a designated percentage of the owners at any time approve making the S election. Exiting out of S status is easier than electing into it. For the organization that wants to require something more than a simple majority to trigger such a revocation, the answer is a separate agreement among the shareholders that provides that no shareholder will consent to a revocation absent the approval of a designated supermajority.

The eligibility requirements for an S Corp (qualifying shareholders, number of shareholders, one class of stock, etc.) are traps that can limit flexibility for an S Corp and result in the loss of the favorable S status for taxation. An S Corp has no capacity to structure special allocations among its owners. Income and losses are allocated according to stock ownership percentages. A C Corp’s conversion to an S Corp is far easier from a tax perspective than a conversion to a partnership.

Another factor to be evaluated in the entity selection process is whether the owners want to structure different types of ownership interests in the entity. Income rights, loss rights, cash flow rights, or liquidation rights may need to be structured differently for select owners to reflect varying contributions to the enterprise. An S Corp is extremely limited in its ability to create different types of equity ownership interests. It is limited to voting and non-voting common stock, all of which must have the same income, loss, cash flow and liquidation rights.

The third factor that affects the choice of entity decision relates to the tax costs of getting earnings out of the enterprise and into the hands of the owners. The challenge for S Corps, LLCs, partnerships and sole proprietorships usually is no big deal. Profits generated by the business operations are taxed directly to the owners, so the distribution of those profits in the form of dividends or partnership distributions carries no tax consequences.

The possibility of the enterprise generating tax losses, at least for a period of time, should be reviewed. The objective here is to try to funnel those losses into the tax return having the highest marginal tax rate. The threshold issue is whether the losses should be retained in the entity or passed through to the owners. Losses sustained by S Corps, LLCs, partnerships and sole proprietorships are passed through to the business owners. When losses are anticipated in the initial years of a business, using a pass-through entity may generate a tax advantage if the owners have other taxable income against which those losses can be offset, within the limitations of the passive activity rules, at-risk rules and basis hurdles previously described. The advantage is that the losses may produce immediate tax benefits. In contrast, if a C Corp is used, the losses realized by a start-up business will generate no tax benefits until the corporation generates taxable income in later years.

In planning to pass through losses to the owners, never lose sight of the fact that the losses, even if passed through, may produce no benefit if one or more of the three loss hurdles described above get in the way. The at-risk and passive loss hurdles usually are not affected by the type of pass-through entity selected. The basis hurdle is different in this regard. The general rule is that losses generated by a pass-through entity are not available to an owner of the entity to the extent that the cumulative net losses exceed the owner's basis in the entity. If a decision is made to use a pass-through entity to take advantage of early losses, this basis difference may be an important factor in opting for an entity that is taxed as a partnership. In some cases, it may be possible to accommodate this situation in an S Corp by having the shareholders personally borrow the funds and then re-lend those funds to the S Corp.

This loss pass-through factor, perhaps more than any other factor, underscores the value of quality projections of the business operations for the first few years and an evaluation of the individual tax positions of the business owners. The issue of control might affect the choice of entity analysis in some cases. A corporation, either C or S, and a limited partnership automatically offer this type of ultimate control in favor of the majority, absent a special agreement to the contrary.

LLC's are different only in that the control rights need to be spelled out in an operating agreement among the owners. In some cases, the fear is that the need for a single operating agreement may result in more dialogue, more negotiation, and more compromise. Beyond the personal discomfort of having to specifically make such demands, the demands themselves may fuel suspicions, undermine loyalties, or, worst case, trigger the departure of a valuable minority player. The alternative option is to walk down the path of building into the operating agreement "mutually acceptable" minority rights through supermajority voting requirements and conditions to the exercise of majority rights.

Reviewing the factors in a given situation hopefully will enable you to select the best type of entity for your business and understand the primary and collateral consequences.

One conclusion is fairly obvious. The C Corp is a very different creature from the other forms, all of which are pass-through entities. A principal distinction for almost every factor exists with respect to the C Corp. The starting point for many clients will be to take a hard look at the C Corp as an alternative. If it fails to pass muster (and it will in many situations), the alternative pass-through entities, LLC and S Corps, should be closely and carefully evaluated.

(Last Updated October 31, 2016)