Limited Liability Companies and S Corporations are both fast becoming more and more popular as business organizational vehicles for those looking for the benefits of limited liability protection while at the same time seeking the same pass-through taxation benefits of partnerships. They both offer attractive solutions to companies wishing to reap these benefits. While at first glance they may appear quite similar, offering similar benefits and features, they actually differ in many substantial ways.
The Small Business Job Protection Act of 1996
LLC formation really came unto its own at the end of 1996 when the “check-the-box” taxation regulations were passed and LLCs were allowed to enjoy, among other things, limited liability, flexibility of management, and the option to “check the box” and elect pass-through taxation. In this same time frame, corporation rules were being revised significantly in order to allow certain corporations that met sub-chapter S requirements to enjoy limited liability protection while acquiring the ability to enjoy pass-through taxation in the same manner as a partnership. These changes were enacted by Congress in order to meet the demands and outcry from lobbyists that something be done to alleviate the tax plight faced by small businesses. The act came to be known as the Small Business Protection Act of 1996, and consisted of 17 statutory amendments to corporation taxation law. Among other provisions, these amendments enabled S corporations to have up to 75 shareholders, and also allowed an S corporation to own any percentage of stock in a C corporation, though the reverse is not true–a C corporation or LLC cannot hold stock in an S corporation. S corporations have to follow strict stock classification and ownership rules.
These changes forced many people that were immediately “sold” on the LLC formation for their company to re-consider this new sub chapter S formation. However, with careful review and guidance, it is apparent that there are situations where it is more beneficial to a company to retain the LLC status, and conversely, there exist situations where it is advisable to elect sub chapter S status.
The S Corporation
Having S corporation status provides for a few substantial benefits for a corporation. First and foremost, of course, is the goal of achieving limited liability, or mitigating the impact of personal law suits or other forms of debt incurred by individual shareholders, against shareholders, and protecting against these same lawsuits or adverse judgments impacting the corporation as a whole, or the rest of the shareholders as individuals. This goal is mostly accomplished with the formation of a sub-chapter S corporation, and these asset protection benefits are true of both the traditional corporation and the S corporation. However, where the s corporation really differentiates itself from the more traditional corporation is the pass through taxation benefit. This enables the S corporation to be taxed in much the same fashion as a partnership, with no company-level taxes (other than in those states that charge franchise fees regardless of the formation type of the company). There is also a limitation placed on the number of shareholders an S corporation, with that number set by the IRS squarely at 75. Most corporations that meet this size threshold elect S corporation status because the pass-through taxation assures that the corporation avoids the double taxation pitfall that is inherent to the standard corporation.
Qualifying for S Corporation Status
There are a number of requisites that must be met in order for a C corporation to qualify for S corporation status. First and foremost, if a new corporation, then the corporation must elect this status within the first 75 days of formation. The corporation must be a “conventional,” for-profit corporation that has only one class of stock. The shareholders in the corporation must be U.S. Citizens or Permanent Residents in good standing at the time of stock acquisition. There can be no more than 75 shareholders, and the passive income of the corporation must not exceed 25% of its gross revenue. If it is an existing corporation, the corporation must not have lost sub-chapter S status in the last 5 years. These are the basic requirements, but bear in mind that laws will differ from state to state with respect to state taxation of corporations, and some states, like Texas, does not recognize S corporation status.
S Corporation Draw Backs
S Corporations are really nothing more than a corporation that is allowed to enjoy pass-through taxation and similar partnership-type benefits. Accordingly, they are subject to the same stringent organizational requirements as corporations, and this means that they must also establish and abide by the corporate formalities that any corporation is subject to. These corporate formalities are an absolute necessity when operating as a corporation in order to properly enjoy limited liability and to maintain the integrity of the “corporate veil”–a hallmark of the separate entity status of the corporation.
Passive Income Caution
Any income generated by an investment that a corporation invests in is know as passive income, and this income is subject to scrutiny as part of the sub-chapter S qualification of a corporation. This differs markedly from active income that is generated as a direct result of products or services rendered during the normal course of business by a corporation to its clients. In a sub-chapter S corporation, passive income is limited to 25% of revenue–any passive income generated past this threshold for three consecutive years will subject the corporation to having its S status revoked by the IRS.
The Limited Liability Company (LLC)
The LLC form allows for an unlimited number of shareholders (known as “Members”) to enjoy similar tax advantages and protection from liability as a corporation, while at the same time enjoying the separate entity status the protections that affords from liability, asset seizures, etc Further, unlike an S corporation, the LLC is not subject to the traditional corporate formalities and thus enjoys a number of management and organizational flexibilities that are just not available to an S corporation. These advantages would not be available to the company whether they formed as a simple partnership or a corporation. The major tax advantage, of course, is that of the pass through taxation. The profits or losses of the company pass directly through to the members and are not subject to company-level taxation. The LLC simply files a Form 1065 as a company, then lists each individual’s income as taxable profit via an attachment known as form K-1. This pass through taxation is one of the hallmarks of the tax advantages available to an LLC, and allows it to avoid the double taxation pitfall that standard C corporations are subject to. The net profit at the company level of an LLC is not viewed as member earned income and thus does not subject the members to self-employment tax.
LLC Flexibility via the Operating Agreement
Whereas the S corporation is bound by the strict rules of the corporate formalities and the necessity that it adhere and abide by them, the LLC knows no such limitations. Much of this flexibility is provide by the Operating Agreement. The Operating Agreement of an LLC is an executed agreement by its members outlining the purpose of the company, it’s management structure, and any duties, rights, assignments, or responsibilities of the members and managing member that are necessary for the formation and continuity of the LLC. Operating Agreements are not a strict requirement of any state, but they are considered a “best practices” procedure and are highly encouraged. They truly define the incredible flexibility of management and structure of an LLC.
The Operating Agreement can be compared or likened to the by-laws of a corporation or the partnership agreement in a simple partnership in that it outlines the organization, member rules, regulations, management and business intent of the LLC and it’s members. It can be used to override the default rules imposed upon an LLC by a state’s LLC act. An example of this type of override is when a particular member contributes a significant percentage of the operating capital to the LLC and the other members agree that this member should have increased voting power or other such rights–this can be proportionate to the amount invested, or any number that the membership agrees upon, but it would be formalized as part of the operating agreement.
Eligibility for Members or Stockholder
The LLC is clearly much more flexible with respect to whom or what is allowed to maintain an equity share (membership) in the company. Almost any individual or entity can be a member in an LLC, and there are no restrictions with respect to citizenship status or residency. The S corporation, on the other hand, is subject to strict shareholder rules that basically dictate that shareholders be U.S. citizens or permanent residents at the time the stock is acquired, and under no circumstances are corporations allowed to own shares in an S corporation (this list includes LLCs, partnerships, or standard C corporations). There are a small number of specialized trusts that are allowed to own sub chapter S corporate stock, but these are relatively rare exceptions
Another noteworthy difference is with respect to the class or types of stock available in an S corporation vs. an LLC. An S corporation is only allowed one type of stock, with no exceptions, and care must be taken not to create a second class of stock lest the S status be jeopardized. IN direct contrast, an LLC can have varying levels of stock and interests in the LLC so long as these are outlined in the Operating Agreement.
LLC members filing returns as individuals and shareholders of an S corporation are both subject to the same marginal tax rate of 39.6%. We also know that the standard C corporation is taxed at the rate of 35%, significantly lower than LLC or S corporation rate. Thus, it would be beneficial to have in place as a member a C corporation that is taxed at its marginal rate versus an individual member taxed at the higher individual rate.
Another distinction arises when discussing the payment for services rendered with membership interests or stock. If a potential member of an LLC is paid for services rendered in the form of membership shares, the transfer is treated as guaranteed interest and thus gross income and subjects the payment to taxation at the fair market value of the shares. This taxation can be circumvented if the new member immediately makes a capital contribution or transfers assets to the LLC. If in cash form, the amount can be as little as $500 contributed.
In comparison, a corporation is treated substantially different. When stock in a corporation is received in exchange for services or products rendered, this stock is fully taxable, with the exception of transferable or forfeitable stock.
Accounting Method – Cash or Accrual Basis?
As a rule, LLCs are not permitted to use the cash or modified-cash basis accounting system, and must adopt the accrual basis accounting method, with very few exceptions. These exceptions are limited to an LLC who did not generate losses, or one in which the members are professionals that practice in the same area that the LLC operates in.
The S corporation, however, can elect either the accrual method or cash/modified cash basis accounting methods, with the usual obvious business necessities observed.
In an LLC, certain distributions, such as appreciated property, are not treated as gains or losses and hence free from taxation.
In an S corporation where no profit is realized but a distribution made to a shareholder, the distribution is treated as return of capital and not subjected to taxation
Which Organization Method is Best for my Company? Should I Organize my Enterprise as an S Corporation or an LLC?
If you intend for your corporation to have more than a few shareholders (but less than 75) and you can appreciate the benefits of pass-through taxation while at the same time understanding the potential pitfalls involved with the “taxation irrespective of distribution,” and you meet the legal requirements outlined above, then the S corporation can go a long way towards making your business profitable and attractive to the right investors.
However, there certainly are very quantifiable benefits to forming as an LLC rather than an S corporation . For example, while a Sub-chapter “S” corporation may allow for many of the same protections and asset distribution facilities, it is limited to between 75 and 100 shareholders, and none of these shareholders can be in the form of a Corporation or IRA’s (in direct contrast to an LLC which does permit corporations as “Members”)–thus limiting the “S” option to smaller organizations or forcing the buyback or buyout of stockholders for those organizations wishing to convert. Further, with the guaranteed operating and management flexibility afforded by the Operating Agreement, and the freedom from the very stringent rules and procedures imposed by the necessity of the corporate formalities that accompany an S corporation, the LLC can be the more attractive option in most cases.