LLC Versus S Corporation Versus C Corporation

better choice for your business. The following is a discussion of the differences that most typically impact our clients.

INITIAL CONTRIBUTIONS BY OWNERS ON FORMATION LLC. Members generally may contribute assets in exchange for capital interests without incurring tax. However, a FORMALIZING member may incur tax if (a) the member YOUR FIRM: contributes encumbered assets (to the LLC VERSUS S CORPORATION VERSUS C extent the member’s contributed CORPORATION liabilities allocated to the other members exceed such member’s tax basis in its by Stephanie L. Chandler1, Jackson Walker contributed assets and its share, of the L.L.P. LLC’s liabilities), (b) the LLC is an investment company, or (c) the contribution is a disguised sale. A s we work with entrepreneurs in member may also receive a profits setting up the structures for their interest in the LLC in exchange for A new ventures, one of the first services in a tax-free manner. questions we are asked is what is S Corps and C Corps. Shareholders the right entity to use. For most generally may contribute assets in entrepreneurs, we find that the most exchange for stock in a controlled frequently used entities are limited corporation without incurring tax. liability companies (“LLCs”), traditional However, a shareholder may incur tax if corporations (“C Corps”) and (a) the shareholder contributes S corporations (“S Corps”). Each of these encumbered assets (to the extant the entities are similar in many areas and shareholder’s contributed liabilities generally provide limited liability exceed the shareholder’s tax basis in its protection to their owners from the contributed assets), or (b) the entities’ creditors, including those that corporation is an investment corporation. make claims in disputes with the entity. Unlike an LLC, a shareholder may not However, because these entities also receive additional stock in exchange for differ in many ways, one entity is often a services in a tax-free manner.

Resulting Comparison: In general, with 1 Stephanie Chandler is a partner with the law proper planning, owners may form each firm of Jackson Walker L.L.P. Ms. Chandler's entity without triggering tax. In addition, practice consists of representing corporate clients with proper planning, each entity may in transactions ranging from corporate formation receive publicly-traded securities and to public offerings of securities and SEC compliance matters. Her experience includes cash without triggering tax. When entity formation, minority and women owned encumbered assets are contributed that business certification, venture capital trigger tax, an owner may incur less tax transactions, mergers, acquisitions, divestitures, on formation with an LLC. Owners who and contract negotiations.

Copyright © 2009-2010, Stephanie L. Chandler will provide services and want a greater However, if individuals and revocable share of the profits (in excess of what trusts will be the only owners and there is their capital contributions justify), may no desire for different classes of prefer using the LLC since the profits ownership with different rights to share interest may be received without in profits (or only voting and nonvoting immediate tax. interests/stock), either entity DIFFERENT TYPES OF SPECIAL SITUATIONS generally should OWNERSHIP INTERESTS suffice. LLC. An LLC has no  If you plan to start a rental real estate restrictions on the business and want a step-up in basis in your HOW MANY TIMES number or type of LLC interest (and the related real estate) at WILL THE SAME death, an LLC is usually the best choice. DOLLAR BE TAXED owners. Various Generally, an S Corp should not hold real estate classes of ownership or highly appreciating investments. LLC. Unless a interests with special election is different voting,  If you are forming a service business made, an LLC distribution and and want to minimize your employment taxes, should be taxed as an S Corp may be the better choice. liquidation rights are a flow-through permitted.  If you anticipate losses in the first years partnership. of your business and want to deduct the Accordingly, while C Corp. A C Corp has maximum amount of losses, or if you want to no restrictions on the an LLC (with more use special allocations of tax items, an LLC may than one owner) number or type of be a good choice. As your business later owners. Various becomes profitable, an LLC may generally be will file an annual classes of ownership converted to an S Corp on a tax-free basis partnership federal (unless the LLC’s debt exceeds its tax basis in its interests with income tax return assets), whereas the conversion of an S Corp to (Form 1065), the different voting, an LLC is a taxable event. distribution and LLC itself will not liquidation rights are pay income tax. permitted. Instead, the LLC’s items of income, gain, loss and deduction S Corp. Owners generally may not generally will flow through to its include corporations, partnerships, LLCs members in proportion to their and some trusts, but may include respective interests and will be taxed on individuals and revocable trusts (as used the members’ respective income tax for estate planning). An S Corp may only returns. have 100 owners. Voting and nonvoting common stock is permitted, but all With proper planning, the members may common stock must otherwise have the make special allocations of various items same distribution, liquidation and other of profit and loss to the members in economic rights. Preferred stock is not different percentages and do not need to permissible. share proportionately in each item. The S Corp is also generally a Resulting Comparison: LLCs and C Corps S Corp. provide more flexibility in terms of flow-through entity that files an annual permitted owners and types of ownership federal income tax return (Form 1120S); interests. however, if the S Corp was previously a C Corp, there may be an additional tax on

Copyright © 2009-2010, Stephanie L. Chandler built-in gains existing at the time of the DISTRIBUTING THE SPOILS conversion. The shareholders pay tax on LLC. When the LLC distributes assets to their proportionate share of the net pass- its members, the members generally will through items allocated to them from the not be taxed on the distributions. S Corp. The shareholders must share However, a member may incur tax if proportionately in each pass-through (a) the member receives cash or item and no special allocations may be marketable securities and the value of made. such assets exceeds the member’s tax C Corp. The C Corp is not a flow-through basis in its LLC interest, or (b) the entity. It must file its own tax return and member is relieved of debt in an amount then each of its shareholders must pay that exceeds the member’s tax basis in its the income tax applicable to any LLC interest If a member receives a dividends that are distributed to the distribution of assets (other than cash or shareholders. If a profitable company is marketable securities), the distribution growing, this may be beneficial if the generally will not trigger tax. corporation has a lower tax rate than its S Corp. An S Corp’s distributions to its shareholders. The funds may be retained shareholders are generally nontaxable to by the corporation and no distribution is the extent of the respective shareholders’ necessary for the shareholders in relation tax basis in their stock. However, if the S to their tax obligations. Corp distributes an asset to a shareholder, Resulting Comparison: LLCs and S Corps the distribution will trigger taxable gain generally offer one level of tax to their to the extent the fair market value of the owners, but only the LLC allows special asset exceeds its tax basis. allocations of income, gain, loss or C Corp. A C Corp’s distributions of cash or deduction among the owners. C Corps are assets to its shareholders are generally taxed and then their shareholders are taxable. taxed to the extent dividends are distributed out of the corporation’s Resulting Comparison: When profits. distributing assets to owners, the LLC may result in less taxes. However, most ordinary distributions of cash from either an LLC or an S Corp to their owners will be tax-free since the owners already paid tax on their share, of the flow-through items. Distributions from a C Corp are generally taxable to the recipient.

EMPLOYMENT TAXES

LLC. Generally, members who actively $1,450 (2.9% on the compensation). The perform services are subject to shareholder would be left with $74,850. employment tax on their entire share of One additional item of note, S Corps the LLC’s net income. However, if an LLC allows the owner-employee (so long as is engaged in a rental business, a required levels of ownership are met) to member’s share of the net rental income take an above-the-line deduction for generally is not subject to employment health insurance premiums paid for by tax. For example, if an LLC (a service the employee for the employee or such business) allocated net income of employee’s family members, as long as $110,000 to a member, the member those premiums are reimbursed by the would incur the following federal taxes: S Corp. (a) income tax of $27,500 (assuming a 25% rate), (b) social security tax of Resulting Comparison: An S Corp or C $12,648 (12.4% on income up to Corp may be a good choice when the $102,000 wage base in 2008, and (c) owners are concerned about employment Medicare tax of $3,190 (2.9% on all taxes. However, if an owner’s income). The member would be left with compensation is already above the wage $66,662. base from other sources, the main difference between

S Corp and C Corp. SPECIAL SITUATIONS (CONT.) the LLC and an S Corp Shareholders are or C Corp (on income only subject to  If you own agricultural properties taxed as employment tax on (such as farm land) and want to operate your business out of an entity for liability protection compensation) will their compensation and business reasons, and want to start be the Medicare tax but not on making gifts to your descendants while still (2.9%). In addition, distributions. maintaining control over most business more complex tax However, a share- decisions, an LLC is the better choice. planning may be done holder’s  If your business operates in several with multiple entities compensation must states, a more complex business structure (LLCs, S Corps, C not be unreasonably utilizing multiple types of entities (LLC, S Corp Corps or limited low; otherwise, some and/or limited partnership) may produce the partnerships) to help of the shareholder’s best income tax result. minimize employ- distributions may be ment tax issues while recharacter-ized as utilizing the benefits disguised compensation. To demonstrate, of LLCs/limited partnerships. if an S Corp (a service business) paid $50,000 to a shareholder as LOSSES & TAX BASIS compensation and $60,000 as a LLC. A member may deduct its share of distribution ($110,000 total), the the losses up to the member’s tax basis in following federal taxes would be imposed: its LLC interest, subject to at-risk and (a) income tax of $12,500 (assuming a passive activity loss limitations. The 25% rate) on the compensation and member’s tax basis in its LLC interest $15,000 on the distribution; (b) social generally equals (a) the member’s tax security tax of $6,200 (12.4% on the basis in its contributed assets, less (b) the compensation), and (c) Medicare tax of member’s contributed liabilities assumed by the LLC, plus (c) the Member’s share of

Copyright © 2009-2010, Stephanie L. Chandler the LLC’s liabilities, plus (d) the member’s takes a step-up in basis equal to fair allocations of income, less (e) the market value. As a result, the LLC may member’s allocations of losses, and less make an election (the 754 election) in (f) the fair market value of assets and which the LLC’s assets related to the cash distributed to the member. deceased member’s interest may also receive a step-up in basis to the extent of S Corp. A shareholder may deduct its share of the losses up to the shareholder’s the fair market value of the decedent’s tax basis in his or her stock, subject to at- interest. A 754 election may also be made risk and passive activity loss limitations. when a member sells or transfers its LLC The shareholder’s tax basis in its stock interest during life. generally equals (a) the shareholder’s tax S Corp or C Corp. Upon the death of an basis in its contributed assets, less (b) the individual shareholder, although the shareholder’s contributed liabilities deceased shareholders stock takes a step- assumed by the S Corp, plus (c) debt that up in basis to fair market value, the the S Corp owes to the shareholder, plus successor shareholder will not receive a (d) the shareholder’s distributive share of step-up in basis in any of its share of the S income, less (e) the shareholder’s Corp’s or C Corp’s assets. distributive share of losses, and less (f) Resulting Comparison: With the 754 the fair market value of assets and cash election, a successor owner in an LLC will distributed to the shareholder. A likely have less capital gains tax on the shareholder’s basis does not include any stale of the LLC’s assets as a result of the part of debt that the S Corp owes to third step-up. parties or other shareholders. ntrepreneurs must also be aware of Losses accumulate within the C Corp. the tax liability to the State of corporation and may only be used to Texas. As opposed to an income offset future profits of the C Corp subject E tax, entities with operations in to certain restrictions. A shareholder may Texas must pay the margin tax. Generally, not deduct its share of the losses. the tax obligation for an LLC, S Corp or C Resulting Comparison: If the owners Corp will be the same. anticipate initial losses and the entity will have third party debt, the owners may be rom a legal drafting standpoint, for able to deduct some losses with the LLC; most practical purposes an S Corp however, if minimal losses are expected Fand a C Corp will require the same or the owners have a high tax basis in documentation. A C Corp becomes their interests/stock, either an LLC or an an S Corp solely by filing an election with S Corp may work. If the owners of the the Internal Revenue Service. A C Corp entity do not have offsetting income may require additional documentation to where they could use the losses, a C Corp designate the rights of its different classes may be better to retain the losses to offset of stock often referred to as a Certificate future corporate profits. of Designations or these differences can be set forth in its Certificate of DEATH OF OWNER Incorporation or Certificate of Formation. LLC. Upon the death of an individual member, the deceased member’s interest

any other factors may impact the assist with determining how best to choice of which entity best fits an address issues such as the relationship M entrepreneurs business plan. among owners, the management Successful entrepreneurs structure of the entity and the desirability typically begin develop a close for future investors. relationship with good advisors, including both accountants and legal counsel. These professionals can This article is published as an informational resource. It is not intended nor should it be used as a substitute for legal advice or opinion which can be rendered only when related to specific fact situations. For more information, please contact the authors: Stephanie L. Chandler 210.978.7704; [email protected]