TAX BREAK

 

Choosing a Business Entity by Rebecca L. Maahs

 

The advantages of a limited liability company (“LLC”) over other types of business entities are substantial and numerous. Both LLCs and S Corporations have two key common attributes that make them attractive to the average business owner, limited liability and pass-through tax treatment. Limited liability means that the S corporation and the LLC are solely responsible for their respective debts and liabilities. Thus, if the assets of either an LLC or S corporation are insufficient to pay all claims against the entity, neither the members of the LLC nor the shareholders of the S corporation are responsible for the shortfall. The members of the LLC or shareholders may lose their entire investment in the entity but their other personal assets are not subject to the claims of creditors.

 

Pass-through tax treatment means that neither LLCs nor S corporations report the income nor the loss of the entity, rather, the income or loss of the entity passes through and is reported on the personal income tax returns of the members or shareholders, in proportions as they shall agree. Generally speaking, this pass-through treatment can be advantageous for a start-up business because any losses in the early years can be passed through to the members or shareholders and deducted by them from income earned from other sources.

 

As a general rule, LLCs are taxable partnerships and will offer more flexibility for tax purposes than S corporations. For example, property can generally be transferred tax-free by a member to an LLC and also withdrawn at a later date without triggering tax consequences. By comparison, in the case of an S corporation, property can generally be transferred tax-free to the corporation at the time of its organization but later transfers or withdrawals may result in the recognition of gain. Since the S corporation can recognize gain on the distribution of property to its shareholder, it is usually not advantageous to use an S corporation to purchase investment property that is likely to appreciate.

 

 The basis of an LLC member in his or her interest (or the S corporation shareholder in his or her stock) limits the amount of the tax losses from the business that may be passed through to the member or shareholder and reported on his or her personal return. In the case of an LLC, the amount of the LLC’s indebtedness to banks or other third parties is considered in computing the basis of members. On the other hand, an S corporation shareholder’s basis does not include any amount from debt unless the obligation is to the shareholder. As a result, the amount of losses that may be passed through to the S corporation shareholder in the start up years may be less than the amount otherwise available to members of an LLC where bank loans or other outside financing is used to acquire assets or operate the entity.

 

The partnership tax rules applicable to a LLC also permit special allocations to be made among the members. For example, one member may have substantial income from other sources and may want to receive the "lion’s share" of losses during the start-up years. Similarly, one member may be contributing the bulk of the cash and want a "preferred return" where the other member is only contributing intellectual property without much value or future services. Special allocations can be used to address these situations.

 

However, special allocations can only be made by LLCs taxable as partnerships. S corporations cannot make special allocations since with an S corporation, all income, loss, and cash distributions must be allocated proportionately among the shareholders based on their stock ownership. Any distributions not made in accordance with share ownership will result in forfeiture of the S election and double taxation will ensue.   Thus, S corporations are simply not flexible enough in today’s world where different people bring different value to the table and are going to be compensated in unique ways.

 

S corporations do however; have one very important advantage that must be discussed. The most significant advantage of S corporations relates to their employment tax treatment. If all members of an LLC participate in management, all the income of the LLC is subject to self-employment tax whether or not it is distributed to the members. This means that the income of the LLC is subject to self-employment tax (15.3%) on a current basis, even if not distributed,

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