LLC or S-corporation: The basics of entity selection

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One of the first questions an owner establishing a new business must answer is: “Do I need to operate the business as an entity or not and if so, what type of entity?” The general rule of thumb is that, if you are going to have employees or partners, you want to operate the business as an entity to protect yourself from negligence of your employees or partners.

Assuming that you have made the determination to be an entity, the question then is what type of entity should an owner select? The most popular options are an S-corporation or a limited liability company (LLC).

The advantage of the S-corporation is two-fold from a tax perspective.

There is no income tax at the corporate level and therefore there is only income tax at the shareholder level, as opposed to a C-corporation where there is a tax at the corporate level and the shareholder level. It is important to remember that the income of the S-corporation is reported to the shareholder irrespective of whether the revenues are distributed in whole or in part to the shareholder.

The other tax advantage of an S-corporation is that, as long as the owners who work in the business pay themselves a reasonable salary, any extra revenue of the S-corporation can be distributed to the shareholder without imposition of self-employment taxes.

The main disadvantage of an S-corporation, from a tax perspective, is that any distributions made to multiple shareholders must be made on a pro rata basis and at the same time. Therefore, as discussed below, the S-corporation does not work well where there are capital contributions to the S-corporation that are to be repaid on a non-pro rata basis.

Another disadvantage is that appreciated assets distributed from the S-corporation to its shareholders can result in a 35 percent tax on the appreciation. Therefore, S-corporations are never a good vehicle for ownership of real estate.

LLCs are the second main choice of owners to establish a business. The main advantage of an LLC is the simplicity in taxation since the entity is taxed as a partnership. There is no advantage from a self-employment tax as, in most cases, all distributions to an owner (i.e., “Member”) in a limited liability company are subject to self-employment tax. The main advantage however, is unlike the S-corporation’s disadvantage of equal pro rata distributions, LLC distributions to the owners can be structured in any way that meets the economic agreement among the owners as long as those distributions otherwise have substantial economic effect. This is a tax limitation that essentially means that any tax deductions taken must be supported by economic arrangement of the members.

So for example, if two owners were opening a restaurant and one owner was providing the initial capitalization and the other was going to run the restaurant, the LLC could allow for initial distributions solely to the member providing the initial capital so as to return his capital as soon as possible. After such member’s return of capital, there could be equal distributions of cash to the members.

Again, this is not something you could accomplish in an S-corporation.

The other advantage of an LLC is that it is much more difficult for a creditor to obtain an interest in an owner’s ownership position in the business. Creditors more than likely would receive what is simply called a Charging Order, which provides that the creditor is entitled only to receive any distributions of cash or property that would otherwise be made to the owner. This provides for continuity of ownership of the business should one owner get into financial problems outside of the business.

In summary, it is most common that a single-owner business that is an operating business, as opposed to a real estate investment-oriented business, would be established as an S-corporation. S-corporations will also serve multiple owners if there is no differentiation between the economics of the owners since they will share all revenues based on their percentage ownership.

In the context of any type of real estate-oriented business or a business where the economics are not going to be equal in pro rata at some time, the LLC becomes the preferred entity over an S-corporation.

Stinar & Zendejas, LLC is a full-service business and estate planning firm whose members include John M. Stinar, M. James Zendejas, M. Jacqueline Gaithe and Gerald H. Hansen. The firm, which offers free initial consultations, specializes in estate and tax planning, business planning/acquisitions, elder law, securities, asset protection, real estate, commercial litigation, divorce/custody, employment law, probate and estate administration. Find more information at www.coloradolawgroup.com or call 719-635-4200.