Which Pass Through Entity is Good for You?

If you decide on a pass-through entity, which of the several do you choose? Here is a brief discussion of the rules applicable to each.

S Corporation

Limitation of liability gives S corps the edge-for business reasons-over general partnerships, sole proprietorships, limited partnerships (as to limited partners whose partnership activity might expose them to unlimited liability), and LLCs in states that don't allow single member LLCs.

Caution: Limited liability comes at a cost, however, since states may impose a tax on S corps not imposed on entities with unlimited liability.

S corps are subject to a number of significant rules and restrictions:

  • All owners must agree to S corp status. This means that one co-owner can exact a price or impose conditions for his or her agreement.
  • An S corp can have only one class of stock, which means that income, losses and other tax attributes are allotted among stockholders in proportion to stock ownership.
  • The number of co-owners is limited (to 100, with qualifications, counting members of the same family as one stockholder).
  • There are limitations as to who can be co-owners (for example, a nonresident alien cannot) and as to the kind of business that can qualify for as an S corp (for example, an insurance company cannot).

Caution: Failure to meet, or ceasing to meet, these requirements means loss of S status and conversion to C corp status-and C corp taxes.

These limits and restrictions will be contrasted, below, with the more liberal tax rules for partnerships and LLCs.

Note: S corps are often preferred because they are simple to operate. However, they are not suitable for many businesses. The much wider range of options for partnerships and LLCs introduces tax planning complexity which may be more than many or most small businesses can effectively use or understand.

LLCs vs. S Corporations

LLCs and S corps share the same business advantage-limitation of liability. S corps are a bit better understood by the business community because LLCs are new and vary from state to state.

The tax advantages of LLCs, as compared to S corps, are the tax advantages of partnerships. All the points below where LLCs outscore S corps arise because LLCs can choose partnership tax status.

  • LLC can to some degree allocate tax attributes, like income or certain kinds of income, depreciation deductions, etc., disproportionately among members to suit their individual tax situations (unlike S corps limited by the effect of the single-class-of-stock rule).

  • S corp owners can deduct startup or operating losses up to their investment plus any debt that the S corp owes them. LLC members can do the same but can deduct further, up to their share of the debt the LLC owes others.

  • Adding co-owners after the entity is formed is easier with LLCs. An outsider's transfer of appreciated property for an LLC membership interest is tax-free. A comparable transfer to an S corp is taxable unless the new co-owner-transferor (or group of transferors) owns more than 80% of the S corp after the transfer.

  • Complex tax adjustments ("basis adjustments") can be made by the LLC when LLC interests change hands or LLC property is distributed. These adjustments, unavailable with S corps, can have the effect of reducing amounts taxable to certain LLC members.

  • Distribution of appreciated LLC property to LLC members is not taxable to the LLC. Comparable S corp distributions to stockholders are taxable to the S corp.

Tip: Depending on circumstances, S corp status can be preferable to LLC status when the owners leave the business. The LLC is not taxed when appreciated property is distributed to its members, which is a standard form of business liquidation. But the members would be taxed on distributions exceeding the "basis" (broadly, the amount they invested) of their interests. S corp owners, on the other hand, can arrange a tax-free exit, via a corporate reorganization in which they transfer their S corp stock for stock in a corporate acquirer. (Later sale of stock in the acquirer would be taxable.)

Depending on state law, S corps and LLCs may be taxed at the entity level in states where they do business.

LLCs vs. Partnerships

LLCs, with their limited liability for all members, have the edge on general and limited partnerships from a business standpoint. While the federal tax treatment of partners and LLC members is basically the same, there are occasional special tax rules for limited partners (especially self-employment tax rules).

Note: It is not clear whether these special tax rules extend to non-manager LLC members.

Note: LLCs are more likely than partnerships to be subject to a state tax.

LLCs vs. Proprietorships

LLCs, with their limited liability, are preferable, where available, for sole proprietors from a business standpoint. Where the sole proprietor so elects, the LLC is ignored and the proprietor is taxed directly under federal tax rules as if no separate entity existed.

Note: Some states do-and some do not-ignore the LLC entity for state tax purposes.

If you have any questions, please do not hesitate to contact me at dkdowell@dkdcpa.com