by John H. Schapiro

Tax considerations weigh heavily in deciding what type of entity to form when starting a business. In the vast majority of cases, we recommend forming a new business entity as a limited liability company (LLC) or an S corporation (a corporation that files an election to be taxed under subchapter S of the Internal Revenue Code), at least when the owner or owners will be individuals. I will discuss why that is, and when that recommendation does not apply, in another post.

Both LLCs and S corporations are “pass-throughs,” which means that instead of paying income taxes themselves on their business income, they allocate their relevant tax items (e.g., profits, losses, deductions) among their members or shareholders, who must include the items on their own income tax returns and pay the appropriate tax personally. Beyond that, however, there are important, sometimes subtle, differences in how tax rules affect them.

Until the 2013 introduction of the Medicare tax (and the accompanying expansion of the self-employment tax), the factors discussed below almost always led us to recommend forming a new business as an LLC, and they still often do. But if employee-owners will predominate in the business, and they do not need the deal-making flexibility of an LLC, an S corporation will sometimes make more sense today.

Here are some of the important issues that should be considered in choosing between these forms of pass-through entity:

  • Any person or entity can own an LLC, but an S corporation’s shareholders must be limited to U.S. citizens or residents who are individuals, plus some specific kinds of trusts for individuals, pension plans, and charities.
  • S corporations are not permitted to have any stock other than common stock, and all shares must have the same economic rights (they can differ in their voting rights). LLCs are extraordinarily flexible. They can have multiple classes of interests, preferred and common, with different rights, and indeed can have different deals for every investor, and interests that shift back and forth over time.
  • It is very easy to turn an LLC into a corporation on a tax-free basis, if that becomes desirable. It is essentially impossible to turn an S corporation (or any type of corporation) with a valuable business into an LLC without paying significant taxes.
  • If an S corporation runs afoul of any of the technical rules about qualification, it automatically becomes subject to separate corporate income taxes and double-taxation on earnings distributions to its shareholders. Sometimes, it is only when the company undergoes a tax audit that the IRS determines that it lost its S qualification three or four years earlier. If the business has been sold in the meantime – which may well be what triggered the audit – the retroactive tax consequences are severe. LLCs do not have any equivalent issue.
  • Allocating tax items among shareholders of an S corporation is rigidly controlled by IRS statutes and regulations. The IRS regulations dealing with tax allocations within an LLC are dizzying in their complexity, but provide far more flexibility and opportunities to achieve tax efficiencies. This is especially true when one owner or group of owners is being bought out of a business – LLCs are often more efficient.
  • Because of the flexibility LLCs have, it is easy to grant equity interests to employyes without having those interests be taxable. The equivalent incentive programs for S corporations are less tax efficient. However, employees of S corporations who hold small stakes in the company have more beneficial tax treatment for employee benefits like health insurance compared with employees of LLCs with equivalent ownership positions.
  • If a company has tax losses and has relatively high debt leverage, S corporation shareholders may not be able to use those tax losses against other income currently, even if they are active participants in the business. The equivalent owners of an LLC will not have the same limits on the current tax benefits of losses. (Some loss-limitation rules apply equally to owners of both entities.) The flip side of this, however, is that LLC owners who have previously benefited from losses can sometimes have “phantom” taxable income solely because of shifts in the company’s ownership, without receiving any economic benefit. In an S corporation, they would neither have benefited from the losses nor suffered the unexpected income.
  • Where owners are also full-time employees of the business, or otherwise actively involved on a daily basis, their share of S corporation profits over and above salary and bonus is not currently subject to self-employment tax or the additional Medicare tax on investment earnings. One or the other of those taxes will apply to LLC owners, regardless of their active involvement in the business. That represents about a 3% tax rate advantage to S corporations, which goes a long way toward balancing out the factors discussed above that clearly favor LLCs.
  • A company with only one owner, if it is an LLC, will be entirely disregarded for most tax purposes. While that can be a useful planning tool, when the owner is an individual it can also increase the risk of a tax audit. S corporations with one owner do not face the same increased audit risk.
  • Because LLCs are more flexible, and less standardized than S corporations, they require more complicated documents – at least if there is more than one owner – and consequently more attention, both when they are being created and when any issue arises. From one law firm to another, LLC agreement forms can differ considerably. While this can be a real advantage to a sophisticated client, it can also be a source of uncertainty and unpleasant surprise in the future.

A business may start out as an S corporation or LLC, but if it grows to the point where it needs or wants to tap institutional and public equity markets, it will eventually convert itself to a regular, “C” corporation. Converting from one form to the other in that direction does not involve a lot of expense, tax or otherwise.

Until 2013, LLCs were rapidly replacing S corporations as the clear choice for forming a new entity, because of their superior flexibility. However, the introduction of the 2.9% Medicare tax as part of the Affordable Care Act created a real advantage for S corporations in the right circumstances: (a) Their owners qualify as S corporation shareholders. (b) The owners are involved in the business full-time or nearly so. (c) The business will not need substantial financing from passive investors. (d) Finally, the business expects to make substantial profits over and above competitive salaries to its owner/employees, which it will either reinvest in business assets, use to pay down debt, or distribute to its owners.