S Corps vs. LLCs Taxed as Partnerships

7 minutes

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S Corporation Advantages/LLC Disadvantages

  • Sales of equity. S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder restrictions, generally) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler). An LLC will have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will likely need to convert to a corporation before entering the public equity markets, because investors are more comfortable with a “typical” corporate structure.

  • Traditional equity compensation available. S corporations can adopt traditional stock option plans; in addition, they can grant incentive stock options. It is very complex for LLCs to issue the equivalent of stock options to their employees (although they can more easily issue the equivalent of cheap stock through the issuance of profits interests—see below). Incentive stock options also are not available for LLCs.

  • Ability to participate in tax-free reorganizations. S corporations, just like C corporations, can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in a tax-free reorganization under IRC Section 368.

  • Ease of conversion to C Corporation status. It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation. For example, upon accepting venture capital funding, an S corporation will automatically convert to a C corporation. For an LLC to convert to a state law corporation taxed as a C corporation, it is necessary to either convert the LLC to a corporation pursuant to a state law conversion statute, or form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC. Also, converting an LLC to a C corporation may raise issues relating to conversions of capital accounts into proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents.

  • Simplicity of structure. S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock—common stock—and their governing documents, articles and bylaws, are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).

  • Self-employment taxes. S corporation shareholders are not subject to self-employment taxes. S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1. An S corporation structure may result in the reduction in the overall employment tax burden. LLC members are generally subject to self-employment tax on their distributive share of the LLC’s ordinary trade or business income. LLC members cannot be employees for federal income tax purposes and thus cannot receive Forms W-2.

  • Fringe benefits. Only 2% or greater shareholders of S corporations have to include certain fringe benefits in income; generally all fringe benefits of LLCs are included in the income of the members, regardless of their percentage of ownership.

Advantages of LLCs Taxed as Partnerships/S Corporation Disadvantages

  • Flexibility of ownership. LLCs are not limited with respect to ownership participation. There is no limit on the number of members an LLC may have. S corporations, in contrast, can only have a limited number of shareholders. Similarly, LLCs may have foreign members (although upon becoming a member of an LLC, a foreign member may suddenly become subject to the U.S. tax laws and have to file a U.S. tax return filing; additionally, an LLC will have to withhold on any income allocated to a foreign member; S corporations cannot have foreign shareholders (all shareholders must be U.S residents or citizens). As a practical matter, however, an LLC is not a viable choice of entity for a company that will have foreign investors or investors that are themselves pass-through entities with tax-exempt partners, because such investors may refuse or not be able to be members of an LLC.

  • Special allocations of tax attributes. An LLC has flexibility to allocate tax attributes in ways other than pro rata based on stock ownership. An S corporation’s tax attributes must be allocated to shareholders based on the number of shares they own.

  • Debt in basis. An LLC member’s basis for purposes of deducting pass-through losses includes the member’s share of the entity’s indebtedness. This is not the case with S corporations.

  • More certainty in tax status. S corporations must meet certain criteria to elect S corporation status; they must then make an election; they must then not “bust” that status by violating one of the eligibility criteria. LLCs generally do not have to worry about qualifying or continuing to qualify for pass-through treatment.

  • Tax-free distributions of appreciated property. An LLC can distribute appreciated property (e.g. real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions. An S corporation’s distribution of appreciated property to its shareholders results in the recognition of gain by the S corporation on the appreciation, which gain then flows or passes through to the S corporation’s shareholders.

  • Profits interests. It is possible to grant “cheap” equity to service providers through the use of “profits interests” under Rev. Proc. 93-27. See also Rev. Proc. 2001-43. It is more difficult for S corporations to issue cheap equity without adverse tax consequences to the recipients.

  • Payments to retiring partners. Payments to retiring partners may be deductible by the partnership; payments in redemption of S corporation stock are not deductible.

  • Ease of tax-free formation. Appreciated property can be contributed tax-free to LLCs under one of the most liberal nonrecognition provisions in the IRC. Contributions of appreciated property to S corporations in exchange for stock must comply with more restrictive provisions of the IRC to be tax-free (i.e. IRC Section 351) (although this is not usually a problem).

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