Multi-member LLCs are taxed as partnerships unless affirmatively elected to be treated in a different manner.1 Partnership tax can be found in chapter K of the IRS Code. S-Corporation is a reference to the IRS code section, e.g. chapter S. These chapters are similar in that they tax the shareholders and not the corporation, which provides for a single level of tax. However, even a tax novice is going to pick up on the fact that if they are in separate code sections then crazy distinctions emerge. There are specific situations when tax considerations push your choice of entity more towards an S-Corporation than an LLC and vice versa.
This article is fairly dry. I looked for something humorous, but there is not much humor in the IRS Code. Thus, I will be brief. I will put the more technical stuff in the footnotes. Here are some further guidelines:
Use LLCs for Real Estate. Recourse and non-recourse debt is considered capital in a partnership, but not an S-corporation. Real estate can sometimes be financed with non-recourse debt (i.e. the land and building secure the debt and not a personal guaranty). Because both recourse and non-recourse debt are considered capital, it is easier to take deductions2. Additionally, you do not have to take deductions pro rata in an LLC, but must take losses and income pro rata in an S-Corporation3.
S-Corporations cannot take corporate debt into basis. For the same tax reasons as the debt analysis with real estate, if you are using debt, your ability to take losses is limited to the capital at risk, which may be more in an LLC. An S-Corporation shareholder cannot add to stock basis any indirect contributions, such as the amount of corporate indebtedness, even if its repayment has been personally guaranteed by the shareholder, unless the guarantor has made an “actual economic outlay.”4
You cannot do preferred shares in an S-Corporation. If someone is investing and needs to get a preference (e.g. paid first) in equity, and you need flow through taxes, you must structure the entity as an LLC. However, it is hard to do an LLC with preferred structures. While you can do it, you might think about structuring the transaction with debt and equity. LLC operating agreements with preferred structures are complicated and still being worked through with respect to how they should be structured. Instead of having a complicated preferred structure, consider having a portion of the investment be debt (in order to make sure the investor is paid first and has downside protection) and a portion in equity.
You cannot have an incentive stock option plan in an LLC. Incentive stock options (ISOs) are a code section that provide for favorable treatment in a very specific type of employee stock grant. LLCs do not have stock; they cannot utilize this section5. LLCs can utilize profit interest.
Terminology is different in LLCs. One non- tax reason that favors S-Corporations is the nomenclature. LLCs do not have a board of directors, they have board of managers; they do not have stock, they have units; they do not have shareholders, they have members. While LLCs have terms that are analogous to corporation terminology, the use of this nomenclature, I think, causes more confusion than practitioners care to admit. Through the operating agreement, you can put the corporate concepts back in, but personally, if it is important to you to have a true board of directors, then you may want to consider having a true corporation.
So there you have some broad general rules that will hopefully guide you. But as you can tell, and is as often the case when dealing with laws, large pronouncements are being made on very technical points. The attorneys and accountants who are reading this are combing through and finding numerous errors in rationale and places where I have glossed over even more technical points. Thus, I go back to my number one rule of choice of entity: Do what your professional advisors tell you to do and have them review it every couple of years.
Goodrich Law Firm, LLC
1 Thus, when we are talking about LLCs in this article, we are assuming it is a partnership, and we again issue the caveat that even though you can have your LLC elect to be an S-Corporation, the complexity in the election and underlying document usually kills any underlying real or perceived benefit.
2 Each shareholder of an S-Corporation is subject to the at-risk limitation rules under Section 465. This means that loss allocated to a shareholder may be deducted only to the extent that the shareholder is ‘at risk’ unless they are exempt from the ‘at risk’ rules. If there are losses in excess of what the shareholder has ‘at risk,’ they are suspended and carried forward to the next year to be offset against income allocated to the shareholder at that time. See footnote 3 for further explanation of basis calculation in an S-Corporation.
Comparatively, members in an LLC are permitted to increase basis in their interest for their allocable share of entity level debt in accordance with the Section 752 Regulations. This is not true for S-Corporations. Also, if real estate is secured by non-recourse debt, the LLC members can qualify for their share of the debt under the ‘at-risk’ exception in Section 465 (b)(6), which is not applicable to S-Corporation shareholders.
The ‘at-risk’ rules also apply to members of an LLC. Usually most debt of the LLC is non-recourse. No member will be able to include it in basis for ‘at-risk’ purposes. There is an exception, an LLC member who personally guarantees a debt of the entity will be ‘at-risk’ where his S-Corporation shareholder counterpart may not be. (Remember a personal guarantee does not increase basis in the shareholder of an S-Corporation).
3 If an LLC acquires a piece of property which is not personally guaranteed, the company has ‘non-recourse’ debt. In an LLC, non-recourse debt can be allocated to member’s basis disproportionately to their percentage of ownership. For example, two people are members of an LLC 50/50. The LLC purchases a piece of property with debt without the members having to be liable for the debt. Let’s say the debt is $100,000. Instead of distributing it $50,000 to each partner, you can distribute $20,000 to one partner and $80,000 to another partner.
4 Basis of a shareholder of an S-Corporation can increase his or her capital basis in the following ways:
1. By the amount of funds or basis of property contributed to the capital of the corporation.
2. By the amount of funds advanced to the corporation in the form of a loan (Section 1366(d)).
5 Precisely replicating an ISO may in theory be possible through the contractual flexibility of an LLC, but I have never personally seen it done, and options in LLCs are extremely complicated.