Content Page

There follows a brief outline the advantages and disadvantages of various forms of business entities. The choice for the vast majority of our clients will come down to three entities. The C corporation, the S corporation or the limited liability company (LLC).^{^[1]}

We rarely recommend C corporations except in the case of high-income individuals needing or desiring self-provided employment benefits. For this reason we have limited our discussion of C corporations. We typically recommend the S Corporation for actively managed businesses that are expected to produce substantial ordinary income, but with little likelihood that the value of the entity's assets will increase in value, and we generally recommend the LLC (taxed as a partnership or a sole proprietorship) for passive investments, especially rental real estate, and where the assets are likely to appreciate in value.

The following chart compares the S Corporation and LLC based on desirable characteristics:

	S Corporation	Limited Liability Company
Non-Tax Characteristics:
1. Limited Liability	X	X
2. Retention of Control	X	X
3. Continuity of Life	X	X
4. Restrictions on Transfer	X	X
5. Restrictions on voting rights	X	X
6. Creditor Protection		X
7. Simple and Inexpensive to Form	X
8. Simple and Inexpensive to Operate		X
Tax Characteristics:
1. Partnership Tax Treatment		X
2. No restrictions on ownership		X
3. Tax-Free Formation	X	X
4. Tax-Free Contributions		X
5. Tax-Free Withdrawals		X
6. Adjustments to Basis		X
7. Self-Employment Tax	X

As you can see from the chart, the two entities both have roughly the same desirable non-tax characteristics, the most important non-tax characteristic being limited liability of the owners for torts and contracts of the entity. However, the S Corporation is probably a little simpler to form, but potentially more complicated to administer, because of the need for a board of directors, officers, annual meetings and minutes, etc. There is no requirement for members of an LLC to have annual meetings, elect a board and officers, etc.

The laws concerning LLC's make it more difficult for a creditor to levy on a member's LLC interest than S stock.

Tax treatment is where the principal differences lie, and for passive real estate investments, the LLC is clearly preferable in most cases, because partnership tax treatment is generally more desirable than corporate tax treatment, even S corporation treatment.

1. No Restrictions on Ownership with LLC. There are many restrictions that apply to the ownership and capital structure of S corporations, while there are none for the LLC. An S corporation's status will be terminated (and the dreaded C Corporation treatment applied) if anyone other than a citizen or resident alien, an estate (for a brief period of time) or certain specially designed trusts or tax-exempt organizations becomes a shareholder. This makes estate planning for the S Corporation Shareholder far more complicated.

2. Restrictions on Capital Structure with S Corp. With an S Corp, there can be only one class of stock (although non-voting shares that are otherwise the same as voting shares will not be treated as a second class of stock). Preferred stock is impossible. LLC's can have preferred interests.

3. Distributions Must be Strictly Pro Rata in S Corp. All owners of the S Corporation must be entitled to distributions of operating revenues and liquidating proceeds pro rata, while the LLC has maximum flexibility in making allocations of income, gain, loss and deduction, subject only to the substantial economic effect test of Section 704(b).

4. Tax-Free Formation/Contributions. Generally speaking, both entities can be formed and funded tax free. However, there is an 80% control test for corporations, which, if flunked, will cause gain on formation if appreciated assets are contributed. With either entity, where liabilities exceed the basis of property contributed, gain will be recognized. With the S Corporation, the 80% control test will prevent future tax-free contributions by an owner, unless other owners with 80% control also contribute additional property.

5. Tax-Free Withdrawals. With the LLC, distributions of appreciated property to the owners will generally not result in the recognition of taxable income either to the entity or to the owners. One exception requires gain recognition to the distributee to the extent cash or marketable securities distributed exceed the distributee's basis in the entity. Another exception is a non-pro-rata distribution of unrealized receivables and inventory items. There are also certain "disguised sale" rules to contend with. But with an S Corporation, if the distribution is treated as a sale or exchange, gain will be recognized by the Corporation, which will flow through to the shareholders. The shareholders, after recognizing the gain, will get a basis increase for their stock, which can be used to offset future income and gain allocated to the shareholder. Nevertheless, gain recognition could have been avoided altogether with the LLC.

6. Basis Adjustment. With an LLC, the basis in the LLC's assets can be elected to be stepped up to reflect an increase in basis of a member’s interest. For example, if the member dies, his heirs receive a fair market value basis in his interest. If a Section 754 election is in effect for the year of death, the basis in the partnership’s assets can also be stepped up, so that if sold, the gain allocated to the heirs is minimized, without any reduction of their basis in the membership interest.

For example: A and B form LLC, each contributing $1,000. The LLC then purchases an office building for $2,000. A dies 20 years later when the office building is worth $10,000. A's child, C, receives A’s interest under his Will. At the date of A's death A and B still each had a $1,000 basis in their LLC interests. C's basis in the inherited LLC interest is $5,000 (its fair market value). The LLC sells the office building the day after A's death and invests the proceeds in marketable securities. If no election under Section 754 is made, C and B will recognize $4,000 of gain each. C will have a basis of $9,000 in her interest and B will have a basis of $5,000. If an election were made under Section 754, B would still recognize $4,000 of gain, but C would not recognize any gain, and would continue to have as basis in her interest of $5,000.

No such election is available to a corporation. This is a significant disadvantage.

7. Self-Employment Tax (SET). This tax is 15.3% of self-employment income up to $90,000. Amounts over this figure are subject to medicare tax of 2.9%. Thus, if an owner already has self-employment income in excess of $90,000, his or her additional liability is 2.9% of his or her share of non-exempt earnings. Rental from real estate and timber sales subject to capital gain treatment (pay-as-cut contracts under § 631) and royalties on oil and gas and the like are exempt from SET in any event. SET is therefore only a concern with an active business generating ordinary, non-rental, income, and should not affect either entity where its only income is rents or royalties. However, for a real estate development in which sales of lots are generating ordinary income, an S corporation might be a better choice of entity because dividends from an S corporation are not subject to SET where a reasonable salary has first been paid to the owner-managers. Determining what is a "reasonable salary" can be an issue and the IRS has been known to challenge salaries that are too low in this context. Limited partners in a limited partnership (LP) are also exempt from SET, and are arguably not required to pay a reasonable salary; however, LP are more complicated than S corporations. With the LLC, however, if the entity is managed by the members, all the members will have self-employment income (except of course on rent and other SET-exempt income). In a manager-managed LLC, arguably (by analogy to limited partnerships) only the manager should have self-employment income, unless other members are performing services for the LLC. If self-employment income is a problem in the LLC, a corporation can be set up to be the manager, and then, arguably, only persons who are performing services as an employee of the corporation will have self-employment income. Otherwise, if an LLC is desired for other reasons, it can elect to be taxed as an S Corporation.

8. Consider a C Corporation for a Self-Employed Individual Who Needs Employee Benefits. The C corporation can provide some employee benefits to a self-employed person in a tax-efficient manner where S corporations and LLC’s taxed as partnerships cannot, but the owner must be able to limit the amount of income earned in the C corporation to prevent double taxation and/or accumulated earnings tax issues. Also, some income splitting opportunities exist with the C corporation because it has its own tax rates. The first $50,000 of C corporation income is taxed at 15%. For individuals in the 35% bracket, running $50,000 of income through the C corporation could be favorable, but this must be weighed against double taxation and higher administration costs for C corporations. The key is to be able to control the amount of income flowing through the C corporation. For instance, the C corporation could be the manager of a manager-managed LLC or general partner in an LP, and could be paid a management fee in an amount determined by the owners. The corporation could then be used to provide favorable employee benefits to the individual manager.

Based on the foregoing comparison, we conclude the LLC is best in asset-based entities where the assets are expected to increase in value and generate rent and or capital gains. S corporations are generally best for active businesses where the value of the business's assets are not expected to increase in value and where self-employment tax will likely be an issue. C corporations should be used cautiously in limited situations described above.

^{^[1]}The reader will notice that these are tax classifications. It should be pointed out that the LLC has the flexibility to elect to be taxed as a C corporation, S corporation, partnership or sole proprietorship (if there is only one member).

Wells Marble & Hurst, PLLC
P. O. Box 131
Jackson, MS 39205-0131
(601) 605-6900