The S corporation is a dinosaur. It has been over-rated and overused as a knee-jerk default entity choice when in fact its usefulness is limited to specific circumstances. Many well-meaning advisers have for years urged their clients to use the S corporation based upon outdated case law or cocktail party conversations that were a poor substitute for continuing education. As a practical matter, the S corporation’s utility is severely limited, primarily because it restricts flexibility, ownership choices, tax savings and liability protection.
The LLC is usually a better choice. Here’s why.
- Limited Liability Companies (‘LLCs’) do not burden you with the same formalities required of corporations under state law in most case. Failure of corporations to observe specific formalities can easily result in ‘piercing the corporate veil’, making the owners personally liable;
- LLCs do not have the severe Ownership Restrictions that subchapter ‘S’ entities do. This allows LLCs much better flexibility in planning for Asset Protection. Thus unlike ‘S’ corporations, LLCs can be owned by Limited Partnerships and trusts that are not likely to be pierced in a lawsuit;
- Tax court cases in the 21st Century have undermined the old argument that anything paid in excess of salary or bonus is a ‘dividend’ not subject to self-employment social security or Medicare taxes. In 2001 the court ruled all payments made to a sole officer were fully subject to self-employment taxes since it held that the payments were wages and not distributions of net income. In 2002 the same conclusion was reached when a professional accounting corporation was before the Tax Court.
- ‘S’ corporations must allocate ordinary income and losses as well as capital gains the same to all shareholders. By contrast, an LLC can allocated them to LLC members who can benefit from them, and this allocation is not required to be made to all.
- There are often have loans between the corporation and its shareholders. Under state law, the board of directors are typically required to pass written resolutions to approve the particulars of loans between the ‘S’ corporation and an ‘interested party’ in order to avoid both legal and tax complications. When auditing, the IRS always asks for the documentation, looking in the corporate record book for resolutions and minutes and for the required promissory note. If the documentation is insufficient, the IRS can deem loan repayments as ‘taxable distributions’. Then ‘S’ status may be revoked, causing large negative tax consequences for the shareholders going back to past tax years.
- Limited Liability Companies do not have the same problem. LLCs members have flexibility in making capital contributions to the Company and thus they can avoid having to characterize the transfer as a ‘loan’ to the company.
- LLCs have what are known as ‘capital accounts’. Each member has one. Unlike its counterpart, contributions of cash or distributions of case are typically not ‘taxable events’ if guidelines are followed. An LLC member’s capital account can be increased or reduced according to whether a transaction is a contribution to capital or a distribution. Because there’s no requirement of the LLC to make distributions on a pro-rata basis, the LLC avoids stumbling over the same speed bumps and negative tax consequences.
- When an ‘S’ corporation makes a distribution of assets to shareholders, it is required to recognize ‘gain’ for tax purposes whereas an LLC is not required to recognize gain when its members receive a distribution of assets.
- When selling the business, LLCs have better flexibility in dealing with the tax and financial consequences, making negotiations with a prospective buyer more simple and less worrisome.
Keep the Big Picture in Mind. On balance, there are still some very limited circumstances when the old subchapter ‘S’ company may still be useful. However in the bigger scope of things, the LLC may be more practical than the ‘S’ corporation, regardless of its usefulness in the 20th Century. Investors and business owners concerned about liability, risk management, privacy, and tax-efficiency should use the LLC as the preferred entity of choice. In the 21st Century, the LLC is the preferable alternative and the national trends in company registrations confirm it.
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