LLC v. S Corp.: Is That Really the Question?

We regularly see continuing education materials, blog posts, publications, and other materials titled “LLC v. S Corp. – Which is Right for Your Business?” or something similar. Regardless of the exact title, these items purport to ask the question of whether an LLC or S Corp. is the better choice of entity. But is that really the question?  For those unaware, an S Corp. is not a type of entity; instead it is just a tax election. Perhaps the more appropriate question would be whether to use an LLC’s default status or elect S Corp. status for the entity-taxpayer. One must first choose a state-law entity type, then make any appropriate tax elections, including an election to be taxed as an S Corp.

Overview

An LLC is a creature of state law. The first LLC statutes were passed in Wyoming in 1977. Since that time, all states have passed LLC statutes. Of course, corporations and partnerships (general and limited) have been around much longer. There are state law differences in how each of these entities operate. Those differences include, but are not limited to, issues relating to management rights, transferability of interests, and creditors rights. State law does not control federal income taxation.[1] Rather, that is controlled by the Internal Revenue Code. Note that there is no S Corp. in this list of entities. For state law purposes, a corporation is a corporation – there is no C Corp. or S Corp.

The Internal Revenue Code has generally taxed business entities under either Subchapter C (C Corp.), Subchapter S (S Corp.), or Subchapter K (partnership). Other businesses may be taxed as sole proprietorships, meaning that those businesses are not separate entities for tax purposes, but rather are reported directly on the sole proprietor’s individual income tax return. Typically with state law, there is variation in taxation of these entities. Those differences include, but are not limited to, pass-through vs. entity level taxation, limitations on number and classes of owners, ability to deduct losses, and tax rates. Note that this list does not contain an LLC. For federal income tax purposes, an entity is a C Corp., S Corp., partnership, or sole proprietorship – there is no LLC (an “eligible entity” under the check-the-box regulations discussed below).

A result of these distinctions is that the question should not be LLC v. S Corp., but rather two separate questions: (1) what is the best state law entity type?, and (b) what is the best tax type?

State Law Choices

Based on above, when forming a legal entity, the choice for state law is generally corporation, LLC, or partnership. Since this writing is focused on the question of LLC v. S Corp., I will only discuss corporations versus LLC’s. However, there may be valid planning reasons to form a state law partnership as well.

Some of the important differences between a corporation and an LLC are illustrated in the following table[2]:

 

Question Corporation LLC
Owners: Shareholders Members
Management: Directors elected by shareholders who appoint officers Flexible structures: member-managed, manager-managed, or, in some states,  officer-managed
Primary Governing Document: Bylaws Operating Agreement
Fiduciary Duties of Owners: Shareholders generally have no fiduciary duties to each other (may not always be the case for closely-held corporations) Members generally owe each other fiduciary duties which may be altered under Operating Agreement
Limited Liability: Shareholders obtain liability protection from corp. debts and corporation should be protected from shareholder debts; however, shares generally are subject to seizure giving creditor full shareholder rights Members obtain liability protection from LLC debts and LLC should be protected from shareholder debts; membership interests generally not subject to seizure, creditors rather merely receiving a “charging order” (akin to garnishment) against interests thereby leaving membership rights (i.e. vote, manage, etc.) with the debtor-member
Transferability: Freely transferrable (although bylaws or other shareholder agreements may limit) Many states limit transferability
Formalities: More formalities including stock certificates, tiered management structures, meeting requirements, often increased annual state filings, etc. Less formalities with an option for a single tier of management (i.e. member-managed), no stock certificates, reduced meeting requirements, limited state reporting requirements, etc.

None of these differences are tax related. Rather, these differences relate to other issues, many of which will be important in deciding the type of entity to form. That said, as can be seen above, the LLC is generally more flexible with simplified formalities versus a corporation.

Tax Choices

Once the analysis has considered the better state law entity type, the question turns to whether that state law entity can accomplish the tax planning goals of the business owner. Often, the LLC will be the preferred entity for state law purposes. Then, it is important to establish what is the preferred tax choice. “Check-the-box” regulations cited below refer to an LLC as an “eligible entity” with the ability to check-the-box of its preferred tax type. If there is only one member of the LLC, the only two choices are sole-proprietorship/disregarded entity or corporation (S or C).[3] If the LLC has multiple members, the default tax type will be partnership.[4] However, the members may elect to be taxed as a corporation (S or C).[5] A state law corporation (often referred to as an “association” under the relevant tax regulations), may not be taxed as a sole proprietorship or partnership and must be taxed as a corporation (S or C).[6] Therefore, as an eligible entity, an LLC has the option of being taxed as a corporation, but a corporation does not have the option of being taxed as a partnership or sole proprietorship. This leaves the LLC as providing more flexible tax options than a state law corporation. Given the simplicity of LLC formation and operation, it often will be the preferred entity type for state law purposes. The available tax flexibility furthers the LLC as the state law entity type which many businesses will use.

Assuming an LLC is the preferred entity for state law purposes, the choice for many small businesses is between accepting default classification (in multi-member LLC’s partnership) or electing to be taxed as a corporation. The S Corp. is most frequently the preferred corporate tax election for small businesses. Both a partnership and S Corp. are passthrough entities, meaning that there is no entity level income tax. Rather, all of the entity’s taxable gain or loss pass through to the owners (subject to certain limitations).

With that, below is a table illustrating some of the primary differences in being taxed as either an S Corp. or partnership:

Question S Corporation Partnership
Number of Owners: Limited to 100[7] At least 2 required, but otherwise unlimited
Owner Types: Generally, only resident individuals[8] Unlimited
Classes of Ownership: Only single class allowed[9] Flexible profit/loss allocations[10]
Owner Cost Basis for Entity Debt: No[11] Yes[12]
FICA Tax: Owner taxed on reasonable compensation but not distributions[13] Owner taxed on all partnership income[14]

Of course, this chart is merely a small sample of the differences in S Corp. and partnership taxation. However, the items above are often important in selecting the tax classification of a legal entity. As can be seen, partnership taxation generally is favorable to taxation as an S Corp other than the ability of a S Corp. owner to receive distributions free of self-employment taxes (“SET”). For many business owners who do not need the benefits of partnership taxation, the SET benefit available for S Corp. owners will be the prevailing consideration. For business owners who benefit from, for example, flexible profit/loss allocations (often preferred returns offered to investors), ownership of the entity by S Corp. ineligible shareholders, or cost basis from entity debts (against which losses may be deducted), partnership taxation will typically be the preferred classification.

Conclusion

Many people only focus on tax issues in analyzing choice of entity. Often, that will be the most relevant consideration. However, that is not always the case. State law differences may be important too. As such, in selecting an entity type, it is crucial to understand the state law differences. For purposes of this writing, those types are a corporation or an LLC (i.e. not an S Corp. which is not an entity type, but rather an elective tax classification). For tax purposes, a corporation can only be taxed as an S Corp. or C Corp. at the option of the shareholders, assuming the requirements for S Corp. tax treatment are met. An LLC may be taxed as a disregarded entity (sole proprietorship), S Corp., C Corp., or partnership. Other than as between disregarded entity and partnership, these tax classifications are optional for the LLC members. Given this flexibility, it is no wonder that LLC’s have become the entity of choice.[15]

Ultimately, LLC v. S Corp. is a false choice. Since an LLC may be taxed as an S Corp. and an S Corp. is not a state law entity type, any materials asking this question simply miss the mark. While I am prone to a heavy eye roll when I see this question raised, I understand the reference likely is to the default classification of an LLC (sole proprietorship or partnership) versus the other passthrough tax type, the S Corp. Regardless of what is intended, it is important to understand that LLC versus corporation should be decided based on the relevant state law considerations. S Corp. taxation versus partnership or sole proprietorship taxation should be decided based on the relevant tax considerations. Especially since an LLC can be taxed as any of these types, it often will be the proper entity to use, electing the tax classification which is preferred.

[1] This writing will discuss only state entity law and federal income tax. There may be state income tax, employment tax, and other considerations in selecting an entity type. While most states follow federal tax treatment, that is not uniform.

[2] These differences are given in only general terms. An exact description of differences will vary from state to state, sometimes widely.

[3] Treas. Reg. 301.7701-3(a)

[4] Treas. Reg. 301.7701-3(b)

[5] Id. and Treas. Reg. 301.7701-1(c)

[6] Treas. Reg. 301.7701-2(b) and

[7] IRC 1361(b)(1)(A), subject to counting certain family members as one person for purposes of this 100 shareholder limited under IRC 1361(c)

[8] IRC 1361(b)(1)(B)

[9] IRC 1361(b)(1)(D), but differences only in voting rights are disregarded. See 1361(c)(4), and Regs. Sec. 1.1361-1(l)(1)

[10] IRC 704

[11] Debt owned by the S corporation will give the shareholder debt. IRC 1366(d)(1)(B).

[12] IRC 752

[13] IRC 1402(a)(2)

[14] IRC 1402(a), but note there is an exception that applies to income of a limited partner (other than guaranteed payments) which under IRC 1402(a)(13) which would apply to a state law limited partnership and, under certain previously proposed regulations to certain members of an LLC. See Prop. Treas. Reg. 1.1402(a)-2(g)–(h).

[15] For additional discussion of some of the reasons, see Schwidetzky, Walter D., “The pros and cons of LLCs,” Journal of Accountancy (Dec. 1, 2018), https://www.journalofaccountancy.com/issues/2018/dec/llc-pros-and-cons.html