Choosing Between an S Corporation and an LLC

Over the past few years, the most common choice is for most new businesses to be structured as a pass-through entity. The two most prevalent types of pass-through entities: limited liability companies (LLC) and S corporations. Between these choices, it is clear that LLC are becoming more popular. However, there are several, often overlooked, reasons to consider the use of an S corporation. 

Business Structure

In selecting the appropriate pass-thru entity, one must first determine if the business contemplated can be structured within the limitations of the entity chosen. For instance, certain limitations exist for S corporations. First, under Code Sec. 1361(b), an S corporation can not have more than 100 owners. Second, only certain types of taxpayers are eligible to be an S corporation shareholder (e.g. a shareholder cannot be a nonresident alien). If the number or type of owners do not fit into these limitations, an LLC would be more appropriate. 

Limitations on Loss 

DeductionsPass-thru losses from both LLC and S corporations are deductible only to the extent that an owner has basis in the entity. However, the calculation of basis varies significantly between an S corporation and an LLC. The members of an LLC may increase their basis for qualified non-recourse debt of the entity (e.g., a mortgage on real property). The LLC members may also increase their basis for loans that the member personally guarantees. On the other hand, debt only increases the basis of shareholders of an S corporation for loans made to the entity itself.

Ownership Interest Transfers

During the life of a business; ownership interests can be acquired and disposed in many different ways. Both types of pass-thru entities can be adversely affected by certain ownership changes. For instance, a transfer to an impermissible shareholder will cause the S election to be invalid. Alternatively, a transfer of over 50 percent of an LLC interest will cause a technical termination of the entity. If a deemed termination occurs gain or loss may be recognized by the owners.

Payments Subject to Self-Employment

In a S corporation, there is a distinction between distributions received as an employee and distributions received as a part of a taxpayer’s ownership interest. An employee-owner will be subject to employment taxes at the individual and corporate levels like any other employee. However, any distributions made on the stock do not create additional employment tax problems. For partnerships, the distinction between payments for services and payments as a return on investment is not as clear. A general partner is subject to self-employment tax on any income of the partnership and any guaranteed payments received. On the other hand, a limited partner will not be subject to self-employment on the income earned by the partnership.In general, distribution of corporation profit among S corp. shareholders are not subject to self employment tax (15.3%). On the contrary, profit distribution among LLC members are subject to self employment tax.