10 reasons to consider a LLC over a S corporation

The Limited Liability Company (“LLC”) and the S Corporation (“S Corp”) are both business organizations that are “pass-through entities” under the Internal Revenue Code: They are not taxed at the entity level because all items of income are picked up by the owners of those organizations on their own tax returns. Of late, there are many who say that the S Corp may be becoming a thing of the past because of the advantages that the LLC has over it. Here are 10 factors you may want to consider in evaluating these advantages.

1. Choice of tax regime

Each LLC is a pass-through entity by choice: Its members have the right to elect to have it treated as a partnership for federal income tax purposes, as a regular C Corporation, or even as an S Corp. The overwhelming majority of LLCs take the first option. No choice exists for the owners of an S Corp. This ability to choose taxation method provides LLCs with a lot of tax flexibility.

2. Who can own

Generally, S Corps can only have individuals as shareholders. There are no such restrictions on the identities of LLC members. Not only individuals (domestic or foreign), but also C Corporations, partnerships, various trusts, and other entities, can be owners of LLCs.

3. Number of owners

An S Corp cannot have more than 100 shareholders (with some funny math for family members, which could allow that number to be a little higher). An LLC has no such limitation.

4. Piercing the corporate veil

The original reason S Corporations were created in 1969 was that traditional corporations provided protection of the shareholders’ personal assets from corporate liabilities, but at the price of double taxation: Corporate income was taxed to the entity on its return, and then could only be paid out to shareholders as dividends, which were then taxed to them on their returns.

In contrast, a partnership avoided that double taxation, but all the personal assets of all general partners were available under state law to satisfy judgments against the partnerships. Both the S Corporation and the LLC give us the best of both worlds: no double taxation and

protection of personal assets from liabilities of the entity.

There is, however, a “bad boy” exception to that protection. The “veil” (or “shield” or “wall”) of

protection for your personal assets can be pierced if you don’t observe the formalities of  operating the business as a separate legal entity from yourselves. 

5. Special allocations

The shareholders of an S Corp must recognize income, deductions, credits, and losses that are passed through on a pro rata basis — in precise proportion to their stock ownership. For example, if Anthony owns 50% of the stock, Barbara 33 1/3%, and Carol 16 2/3%, and the Corporation’s income is $1,200,000, Anthony must pick up $600,000 on his 1040; Barbara $400,000 on hers; and Carol $200,000 on hers. There is no flexibility to do otherwise.

An LLC, on the other hand, has the right to allocate income and loss to its members in a way that doesn’t track the relative ownership interests of each member, as long as there is a substantial economic reason for the allocation. For example, Dave and Elaine each own 50% of the LLC, “one person, one vote,” but Dave contributed $500,000 and Elaine contributed $250,000. The LLC could elect to have, for example, 66 2/3% of the profits allocated to Dave, and 33 1/3% to Elaine, until Dave has received $250,000 more than Elaine, at which point they wish to switch to a 50/50 split. This flexibility is another clear plus for LLCs over S Corps.

6. Ownership classes

With the exception that an S Corporation can have voting and non-voting stock, an S Corp cannot have different classes of stock (i.e., it cannot have common and preferred). An LLC can provide some members with higher rights to distributions and liquidation proceeds than others, which is similar to what would be available to holders of preferred stock in a C Corporation.

7. Distributions of appreciated property

As with C Corporations, if an S Corporation distributes appreciated property, it is treated as having sold the property for its fair market value, and then having distributed cash. For example, if land with a basis of $100,000 and a current value of $300,000 is distributed to a shareholder, there is $200,000 of gain at the entity level. This rule does not apply to LLCs.

8. Ownership interest in return for performing services

If an individual receives S Corporation stock in exchange for rendering services, it is taxable. If a person receives the equivalent in an LLC (a so-called “profits interest”), that is not a taxable event.

9. Entity basis

An S Corporation’s basis in its assets is not changed by a sale or distribution of an asset. In

contrast, a so-called “Section 754 election” allows a step-up to the entity on sales and distributions on death for an LLC.

10. Counting liabilities in basis

The rules for both S Corporations and LLCs state that the owners of those entities can only deduct passed-though losses to the extent of the respective owner’s basis. With respect to

loans made by the entity and guaranteed personally by the individual owners, the rules for calculating basis favor the LLC.

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2022-144652 Exp. 10/24

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