Despite the flexibility and versatility that limited liability companies (LLCs) offer, use of S corporations continues to grow. A recent study conducted by the IRS indicated that there were more than 3,000,000 S corporations operating in the United States, accounting for 59% of all corporate tax returns filed.

When it comes to choice-of-entity decisions, one may wonder whether there is any meaningful difference between an LLC and S corporation. In fact, there is. The purpose of this article is to highlight the major differences between these entities, and provide a framework for effective analysis of the choices involved.

A. Taxable versus Tax Free Distributions
One major difference between an LLC and S corporation is the tax implications of distributing appreciated property to its owners. When appreciated property is distributed out of an S corporation, gain is recognized by the corporation, regardless of whether it is a liquidating or non-liquidating distribution. The gain passes through to its shareholders, who pay tax on that gain. The gain increases their basis in their stock, which ordinarily eliminates gain recognition at the shareholder level. If the value of the property distributed exceeds the shareholders' basis in their stock, however, the shareholders again pay a capital gain tax on the excess amount.

Distributions of appreciated property by an LLC generally trigger no gain recognition by the company or its members. Certain exceptions exist if the distribution consists of appreciated marketable securities, appreciated inventory or unrealized accounts receivables. No such exception exists for real property, however. Consequently, tax practitioners generally recommend using an LLC rather than an S corporation for holding real property investments.

B. Basis Calculation
Another major difference between the entities is how they treat debt when calculating the owners' bases in their partnership or S corporation interests. Basis is critical for both entities because it determines the amount of tax-free distributions, and the losses that are passed through to the owners. For LLCs, all partnership debt is added to the partners' basis in their partnership interest (outside basis), which gives them greater ability to use their losses in the current year and also take more tax-free distributions. The only type of debt that is added to the basis of S corporation shareholders' interest is a direct loan by the shareholder to the corporation. Thus, S corporation shareholders are more susceptible to having suspended losses than LLC members.

C. Other Differences
To qualify for tax free capital contributions, the contributing shareholders in an S corporation must possess at least 80% ownership of the S corporation, by vote and value, following the contribution. Furthermore, S corporations cannot be owned by other entities except certain eligible trusts and estates, and cannot have non-resident aliens as shareholders. LLCs, on the other hand, can be owned by any person or entity, and there is no 80% control requirement to qualify for a tax free capital contribution. Unlike S corporations, the flow-through nature of LLCs is not susceptible to inadvertent termination due to the transfer of ownership interest to an ineligible person or entity.

With respect to operations, LLCs can provide more flexibility in terms of how income, gains and losses are allocated among the partners while S corporation allocations are based strictly on the number of shares owned by each shareholder.

Unlike S corporations, LLCs can be subsidiaries, including subsidiaries of S corporations. In fact, LLCs provide more flexibility than even the Congressionally-sanctioned S corporation subsidiaries - Qualified Subchapter S Subsidiaries (QSSS). Although both wholly owned LLCs and QSSSs are disregarded entities, only the LLC retains its flow-through structure when there is more than one owner. The QSSS is available only when the S corporation is its only owner. If there is more than one owner, the LLC converts into a partnership while the QSSS becomes a C corporation.

D. Employment Tax
The one area where S corporations may have an advantage over LLCs is employment taxes. S corporation shareholders are subject to the self-employment tax on income derived from the entity to the extent that they are paid to them as wages. On the other hand, the distributive shares of the members of an LLC are subject to the self-employment tax, with the exception of certain items such as interest, dividends and rental income. Hence, S corporations provide an opportunity to reduce the self-employment tax burden. Note, however, that the IRS may assess additional self-employment tax in situations where a substantial portion of the S corporation's income is derived from personal services provided by its shareholders. This situation is still evolving and we will keep you updated in future newsletters.

E. Conclusion
In light of the discussion above, the continued growth of S corporations is surprising. In most situations, the LLC is the optimal entity for conducting a closely held business. Of course, if the business is already conducted in a C corporation form, an S corporation election may be the only viable means of attaining pass-through taxation. In the end, the most important consideration is being aware of what each entity has to offer and selecting the entity that works best for the situation involved.

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