Newland's Business Notes

Why LLC Over S Corporation?

Volume 3 Issue 6-- November/December 1999

This is the final newsletter in our trilogy focusing on the new business kid, Limited Liability Companies or LLCs. For the earlier editions, click here.

Previously, I discussed the formal differences between types of business entities. This time, we will discuss some of the advantages of LLCs over S corporations, as well as the converse of this theme -- one advantage of S corporations.

Basis and Loans

Here's an example of a recurring horror story concerning S corporation loans. Slim and Jim started a business in 1998, called Plobon, Inc., by investing $10,000 each for their stock. Plobon borrowed $80,000 and began the business of selling cigar wrappers. The first year, Plobon lost $100,000, all of its available cash.Slim and Jim remained active in the business.

How much were they entitled to deduct on their 1998 tax returns as a business loss stemming from the S Corporation? The answer -- $10,000 each -- their respective bases in their stock, even though the loan to Plobon was probably guaranteed by Slim and Jim, and they would be required to repay the loan to the lender as guarantors, if the corporation could not pay.

Had Slim and Jim borrowed the $80,000 and loaned it to Plobon, the basis of their stock would have been $50,000 each and they both could have deducted $50,000 on their 1998 tax returns.  A loan obtained by the S Corporation does not create basis for Slim and Jim in their Plobon stock. This technically maddening point has created misery for the shareholders of many failed S corporations.

By contrast, for LLCs, the members can include the company's loan in their basis. If Plobon had been an LLC, Slim and Jim could each have deducted the full $50,000 in losses.

Technical S Restrictions

S corporations cannot have more than 75 shareholders, non-resident alien shareholders (foreigners), or most non-individuals, like trusts or estates, as shareholders. LLCs can have all types of owners in any number.

S corporations are permitted only one class of stock, and the allocation of profits, losses, and other tax attributes must be according to the ratio of the shareholders' percentages of stock. For example, if Slim owns 50% of Plobon, then he must receive 50% of the profits, losses, etc. If Slim gives 10% of the stock to Aunt Effie, then she must receive the requisite percentage of profits or losses, even if she never works a day for Plobon.

Salaries and bonuses do not have to march in tandem with stock ownership, so Slim or Jim, or Aunt Effie (if she works for Plobon), may receive compensation in addition to their share of S corporate earnings or losses.

LLCs are not so inflexible as S corporations, and it is possible to vary allocations of profits, losses, and other tax attributes. The sole member of a one-member LLC can report his or her income on Schedule C (business income) of his Form 1040 and need not file a separate return for the LLC. A one-person S corporation must file a corporate income tax return (Form 1120S).

LLCs and Self-Employment Tax

All income earned by an active member of an LLC is subject to self-employment tax whether or not it is actually distributed, while S corporation dividends are not. This means that S corporations can distribute some of the entity's profits (subject to the payment of reasonable salaries and possible IRS scrutiny in an audit) as a dividend, free of self-employment tax.

Many of these, and other similar, technical issues could be discussed at much greater length. Also, many professionals are still adjusting to the new LLC concept, so one may hear competing and valid comments at variance with this newsletter. If you have questions about this subject, call us.

Copyright 1999

Published by the law firm of Newland & Associates, PLC
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Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and tax-related services.

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