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Reasons to Consider a LLC over a S Corporation

Reasons to Consider a LLC over a S Corporation

September 24, 2020
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The Limited Liability Company (“LLC”) and the S Corporation (“S Corp”) are both business organizations which are “pass-through entities” under the Internal Revenue Code: they escape taxation because all items of income are picked up by the owners of those organizations on their own tax returns.

Of late, there are many who say that the S Corp may be becoming a thing of the past because of the advantages that the LLC has over it. Here are five factors you may want to consider in evaluating these advantages.

1. CHOICE OF TAX REGIME

Each LLC is a pass-through entity by choice: its members have the right to elect to have it treated as a partnership for federal income tax purposes, as a regular C Corporation, or even as an S Corp. The overwhelming majority of LLCs take the first option. No choice exists for the shareholders of an S Corp. This ability to choose provides LLCs with a lot of tax flexibility.

2. WHO CAN OWN

Generally, S Corps can only have individuals as shareholders. There are no such restrictions on the identities of LLC members. Not only individuals (domestic or foreign), but also C Corporations, partnerships, various trusts, and other entities, can be owners of LLCs.

3. NUMBER OF OWNERS

A S Corp cannot have more than 100 shareholders (with some funny math for family members which could make that number a bit higher). A LLC has no such limitation.

4. OWNERSHIP CLASSES

With the exception of voting and non-voting stock, a S Corp cannot have different classes of stock (i.e., it cannot have common and preferred). A LLC can provide some members with higher rights to distributions and liquidation proceeds than others, similar to preferred stock in a C Corporation.

5. SPECIAL ALLOCATIONS

The shareholders of a S Corp must recognize income, deductions, credits and losses that are passed through on a pro rata basis. For example, if Anthony owns 50% of the stock, Barbara 33 1/3% and Carol 16 2/3%, and the Corporation’s income is $1,200,000, Anthony must pick up $600,000 on his 1040; Barbara $400,000 on hers; and Carol $200,000 on hers. There is no flexibility to do otherwise.

A LLC, on the other hand, has the right to allocate income and loss to its members in a manner which does not track the relative ownership interests of each member, as long as there is a substantial economic reason for the allocation. For example, Dave and Elaine each own 50% of the LLC, “one person, one vote,” but Dave contributed $500,000 and Elaine contributed $250,000.

The LLC could elect to have, for example, 66 2/3% of the profits allocated to Dave and 33 1/3% to Elaine, until Dave has received $250,000 more than Elaine, at which point they wish to switch to a 50/50 split. This flexibility is another clear plus for LLCs over S Corps.

While “one size fits all” conclusions are inappropriate in financial and business planning, the wind does seem to be blowing in the direction of the LLC.

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