Dear Client:

Here is an overview of the differences between doing business as an S corporation and an LLC. After you have read this information, we can discuss in detail what would be best in your situation. Please note that under the California Business and Professions Code, professional businesses cannot form LLCs. The list of professional businesses includes physicians, engineers, accountants, attorneys, and architects. However, at present we do not have a precise definition of “profession” for purposes of the LLC rule, so we are not sure if realtors, contractors, cosmetologists, etc., are considered “professionals.”

An LLC is easier

Forming and operating as an LLC requires less effort than a corporation. An LLC is not required to have annual meetings or minutes. An LLC with less than $250,000 in gross receipts and less than $250,000 in assets is not required to have a balance sheet. A single member LLC includes income, losses, and deductions on the member’s return. The only filing requirements are Form 568, Limited Liability Company Return of Income, to pay the annual fee based on total income from California sources, and Form FTB 3522, Limited Liability Company Tax Voucher, to pay the annual tax.

Estate planning

Many individuals use the LLC to transfer assets to their children. By contributing property to an LLC, the parents can make small gifts of the property to the children using the annual gift tax exclusion. When the parents die, the value of the property may be reduced for estate tax purposes because the parent does not own 100% interest.

The LLC is superior to the S corporation in this area because:

• The beneficiaries receive a stepped-up basis in the assets of the LLC, providing them with increased depreciation. The IRC §754 election is available to the LLC but not the S corporation;
• While the parent is alive, the beneficiaries can be classified as nonmanaging members and have no say in the operation of the business. This is not possible in an S corporation because the S corporation does not allow for different classes of stock; and
• The LLC may make disproportionate distributions to the parent or the beneficiaries. In an S corporation, the distributions must always be in proportion to stock ownership.

Liquidation

Although there is no double-tax at the liquidation of the S corporation, the shareholder will recognize gain or loss on the liquidation. When an LLC liquidates and distributes assets to the members, the members do not have a taxable event unless the value of cash, inventory, and unrealized receivables is greater than the member’s basis.

Special allocations and depreciation

An LLC, like a partnership, may make special allocations of income or loss based on a member’s contributions. LLC members can even keep separate sets of books, combine them at the end of the year to file the return, and share certain expenses.

For example, a set designer and a costume designer form an LLC. They share an office and telephone and office expenses, but each generates their own income and pays their own expenses attributed to the project. The LLC provides these individuals with a vehicle to calculate their separate profit, allocate shared expenses, and pay the net income to each member as a guaranteed payment.

The LLC is treated like a partnership and, as such, a new owner may take advantage of the IRC §754 election. This election allows the member to step up the outside basis on the assets acquired and depreciate them based on the fair market value of the assets when the LLC interest was acquired. A new shareholder of the S corporation may have an increased basis in the stock but does not get a benefit for the depreciation increase.

(The membership operating agreement should include these items.)

S corporations: formality and familiarity

A corporation is more formal. The benefit to the formality is that it protects shareholders and keeps them informed of the activities of the corporation in which they have invested.

An S corporation may also have more stature in the business world. The LLC is relatively new, and creditors may feel more comfortable doing business with an S corporation than with an LLC.

Tax issues

An S corporation offers the ability to limit payroll taxes. If structured correctly, the shareholder/employee may take a reasonable salary, subject to all employee and employer payroll taxes, and be taxed on the profits as a dividend distribution. This way not all the salary is subject to payroll taxes.

Note: This benefit is reduced when the income exceeds the FICA threshold. After that, the LLC member pays only the 2.9% Medicare tax.

An LLC managing member must pay self-employment tax on their share of the net income from the LLC whether or not it was distributed. The LLC member also pays self-employment tax on the amount contributed to a pension plan. The shareholder/employee’s pension contribution comes directly off the income of the corporate return.

Converting from a single member LLC to a multimember LLC or vice versa will create two different tax returns and accounting issues. An S corporation is not impacted when shareholders change. Also, a 50% ownership change does not terminate an S corporation, whereas when an LLC has a 50% or more change of ownership, a final return and a first-year return must be filed for the old and new owners.

What does each cost?

In California, the cost of either entity is high. The S corporation itself pays the greater of 1.5% tax or $800 to California and the shareholders also pay tax on the income. The S corporation is forgiven the $800 minimum tax in its first year, although it still must pay tax on the net income, even if it is less than $800.

The LLC pays $800 annual tax for all years. There is no first-year-free rule for LLCs. LLCs must also pay the annual fee based on total income, which ranges from $900 for an LLC with total California income of $250,000 to a maximum of $11,790 for total California income in excess of $5 million.

So which is best?

There is no one answer to this question. But first ask yourself this: How much will each entity cost in tax, accounting, and administration? Then decide what structure is best. It seems that for estate-planning purposes, the LLC gets the nod. For a business that needs or wants more established and stricter requirements, the S corporation may better fit the bill.

Sincerely,

Your Tax Adviser