LLC versus S Corporations Overview

For more than a decade, our Charleston business lawyers have realized that the enactment of limited liability company statutes in all 50 states and the adoption of the check-the-box tax regulations, organizing business ventures as limited liability companies (LLCs) has become increasingly popular. The members’ limited liability and flow-through tax treatment are comparable to aspects of S corporations. Nevertheless, there are distinct differences between LLCs and S corporations from both tax and business standpoints.

Deciding between using an LLC versus S corporation to conduct a business is generally premised on a preliminary decision that flow-through tax treatment is desired. In general, flow-through tax treatment means that the entity itself is not subject to tax. Rather, the owners of the business will report their distributive shares of the business’ income, gains, losses, deductions, and credits on their own tax returns. By eliminating the entity-level tax, the overall tax burden upon placing the business’ income in the hands of its owners is reduced.

Although an LLC and an S corporation both provide the desired flow-through tax treatment, an LLC is generally taxed as a partnership under Subchapter K, while an S corporation is taxed under Subchapter S. These provisions are not the same, and the tax treatment of the owners is not the same. The business entity comparison summarizes the tax and business characteristics of LLCs and S corporations. However, some of the more important differences are briefly discussed below.

S Corporation Qualified Business Owners

Probably the most significant difference between a limited liability company and an S corporation is the restriction on who can be a shareholder of an S corporation. Only individuals other than nonresident aliens, grantor trusts, qualified Subchapter S trusts, electing small business trusts, certain estates, qualified retirement plans, and charitable organizations can be shareholders of an S corporation. Thus, an S corporation cannot have as a shareholder a nonresident alien, a corporation, a partnership, a limited liability company, or a non-qualifying trust. For LLCs, no such restriction exists. Any individual or entity can be a member of an LLC. Thus, a nonresident alien, corporation, partnership, another LLC, or any type of trust can be a member of an LLC. This greater flexibility can dictate the selection of an LLC for a particular business venture or in estate planning.

Allocation of Business Income and Business Losses

Another significant difference between limited liability companies and S corporations relates to the allocation of the business’ income and losses among the owners. An LLC, which is taxed as a partnership, is subject to the allocation rules of Internal Revenue Code §704(b). That section generally allows any allocation of income and loss among the members as long as the allocation has substantial economic effect. For example, members who provide capital to the business can be provided a preferential return, similar to interest. Allocations among members may be determined at the end of the year based on the LLC’s operating results and may also vary from year to year. Likewise, distributions to the members may be flexible. For example, members providing capital may receive a return of their capital before any distributions are made to members who do not.

S Corporation One Class of Stock Rule

An S corporation can have only one class of stock, although it may have both voting and nonvoting common stock. Thus, each share must be treated the same as every other share with respect to allocations of income and losses and distributions. Therefore, an S corporation cannot provide a preferential allocation to any shareholder. Similarly, distributions cannot be made to some shareholders and not to others.

Liquidation of Business

The tax treatment of the owners upon the liquidation of an S corporation and a limited liability company is different. Under partnership rules, liquidations can generally be accomplished tax free. Tax liability may arise when the amount of cash distributed to the member exceeds the member’s basis for his or her interest or when unrealized receivables or inventory items (hot assets) are distributed.

In contrast, the liquidation of an S corporation is treated the same as the liquidation of a C corporation: It is a taxable transaction. Any distribution of an asset in liquidation of the S corporation is treated as a sale of that asset for its fair market value. Any gain is allocated among the shareholders and must be included on their individual tax returns even though the asset was not sold to a third party.

Non-Tax Business Issues

Although tax issues will generally be the most critical in deciding whether to organize a business as a limited liability company or an S corporation, business operation concerns should also be addressed.

An LLC and an S corporation should be treated similarly; the owners should not be liable for any debts or obligations of the entity. In the case of an S corporation, which is organized like any other corporation under state law, this is clearly the case. A significant body of case law has developed over the years addressing this issue. Except in unusual circumstances, when attempts may be made to pierce the corporate veil, most practitioners feel quite confident that organizing a business as a corporation (whether taxable as a C or an S corporation) will protect the shareholders from liability as long as the corporate formalities are observed.

For LLCs, however, the law is not as clear. LLCs have been authorized in most states only in the last 15 years. Little case law has developed with respect to business issues such as the liability of members for the debts and obligations of the LLC. Hence, when protection from liability is considered critical, many practitioners may elect to organize the business as an S corporation because of the body of law that has developed in this area.

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Our Charleston business lawyers provide counsel and advice to those entrepreneurs, professionals and businesses who are seeking to launch a new business. We assist clients in everything from the business entity selection during formation to the sale of a business. We not only offer reasonable hourly fee arrangements, but also provide flat-fee or fixed-fee services, hybrid fee services, and contingent fee services for the majority of business transactional matters.