The Advantages and Disadvantages of Various
Entities
"C" Corporations
Advantages
of an LLC Relative to a "C" Corporation
Tax Consequences to
Owners. The primary advantage of the LLC
over the "C" Corporation is in the tax consequences
to owners. As a pass-through entity, the LLC's
income and losses flow through and are taxed to or
deducted by the members, normally retaining the
character they had in the LLC. Thus, there is a
single level of tax, and losses are fully
deductible by members (but are subject to passive
activity rules and the deduction may not be in
excess of their bases in their membership
interests). The income of a C corporation is
taxable, both by the federal government and your
state, at the corporate tax rate. Thus the
corporation and its shareholders may be subject to
"double taxation", when dividends are paid to
shareholders because the corporation pays tax on
its income and the shareholders pay tax on
dividends received from the corporation, and the
corporation is not allowed to deduct dividends as
an expense.
Structure of the Owners
Participation. The owners of the LLC have
greater latitude and flexibility in providing for
the return of an owner's investment. There is also
more liberty in structuring the owners
participation in the enterprise.
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Disadvantages
of an LLC Relative to "C" Corporation.
Retention of Earnings.
A venture that intends to retain substantial
earnings may find the corporate structure
beneficial. It is likely that the marginal
corporate tax rate on the retained earnings (only
15% up to 50K) will be lower than the marginal
rates applicable to individuals. One needs to
carefully study the venture's projections and
calculate the estimated after-tax financial
performance of the venture before making a
decision.
Fringe Benefits. An
LLC taxed as a partnership cannot provide many of
the fringe benefits that a "C" Corporation can.
Members are not "employees" for purposes of the
fringe benefit rules. See, e.g., IRC 5105(9)
relating to accident and health care plans and IRC
#79 relating to group term life insurance. If the
LLC provides members with fringe benefits, the cost
must be included in the member's gross income. In
some states, "C"s can maintain more favorable
asset-protected retirement plans.
"S" CORPORATION
Advantages
of LLC Relative to "S" Corporation
Restrictions on Ownership.
An "S" Corporation offers the advantage of limited
liability for owners, and some of the advantages of
being taxed as a partnership. It does not pay tax
on its earnings, and its profits and losses are
passed through and taxed directly to its
shareholders. However, there are a number of
restrictions on the ownership of and the operation
of an "S" corporation that do not apply to an LLC.
The "S" corporation can have only one class of
stock. Its stockholders can be only natural
persons, and those persons must be U.S. citizens or
resident aliens. An "S" corporation may have no
more than 75 shareholders.
Special Allocations.
Further, an "S" Corporation may not specially
allocate tax attributes to its shareholders. Those
attributes pass through pro rata. This fact
restricts the type of debt the corporation may
issue, hampers efforts to gradually shift control
of family-owned businesses, and in general makes
passive investments difficult to structure.
Deductibility of Losses.
An "S" corporation differs in the ability to obtain
tax basis from its share of the entity's liability,
which determines the extent of losses that may be
deducted by the owners, and their ability to
receive operating distributions tax free. An "S"
corporation shareholder does not share in the
entity liabilities and its basis is limited to the
cash invested. Both an LLC member and a limited
partner increase their basis by the allocable share
of entity liabilities. Moreover, distributions of
appreciated property trigger a gain to the "S"
corporation that passes through to the
shareholders. Also, there is a second entity level
tax on built-in gain, if the "S" corporation was
formerly a "C".
Disadvantages
of LLC Relative to "S" Corporation
The LLC offers the limited liability of the "S"
corporation and pass-through taxation with none of
the "S" corporation restrictions on ownership and
operations. Therefore, we really cannot see a great
deal of general disadvantage. However, there may be
some disadvantages in a special case.
Taxation of LLCs
One-owner LLCs are treated the same as sole
proprietorships. Profits are reported on Schedule C
as part of your individual 1040 tax return.
Self-employment taxes on LLC net income must be
paid just as you would with any self-employment
business.
Multiple owner LLCs are treated as a partnership
by the IRS. The tax return that the LLC completes
and files is IRS Form 1065, Partnership Information
Return. On this form, LLC profits are reported and
allocated to each of the owners according to the
LLC's operating agreement. Each owner is given a
Schedule K-1, which shows each owner's share of LLC
income or loss. The owner then reports and pays
taxes on this income on the owner's annual 1040
income tax return.
Please note that as with a sole proprietorship,
all profits of the LLC are taxed to the owners,
even if they are not actually distributed by the
LLC. This situation could happen when the LLC needs
to use its profits to meet ongoing expenses.
There is a possible third tax treatment that an
LLC could elect if it did not want pass-through
taxation. The LLC may elect to be taxed as a
corporation by completing IRS Form 8832 and
checking the corporate income tax treatment box.
After making this election, the LLC is taxed as a C
corporation by the federal government. Because the
corporate income tax rates for the first $75,000 of
corporate taxable income are lower than the
individual income tax rates that apply to the
taxable income of non-corporate taxpayers, it is
possible a net income tax savings can result from
this tax election.
The state income tax treatment of LLC profits
typically mirrors the IRS tax treatment as
discussed above. Some states have different rules
and for specific information on your state rules
visit your state's web site.
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POTENTIAL MAJOR DISADVANTAGES
OF LIMITED LIABILITY COMPANIES
In addition to any disadvantages of LLCs
compared to other entities, one should keep in mind
the following general drawbacks to the use of LLCs:
The legal ramifications of forming and operating an
LLC, e.g., tax classification is more uncertain
because of the lack of guidance from established
case law and regulations. This may be more
theoretical than real. Other states may not
recognize all of the rights and privileges afforded
to an LLC in your home state. If the LLC has one or
more members who are non-residents of the LLC
state, it must file a list of members and consents
with its annual state tax return. As to any
non-resident member who fails to consent to Your
state tax jurisdiction, the LLC must pay the tax
attributable to the non-consenting member's
distributive share of LLC income. The members of an
LLC may have implied authority to act on behalf of
the LLC and bind the LLC, e.g. signing of deed of
trust (mortgage).
SUMMARY
As a general rule, the LLC will probably serve
well in those circumstances where the limited
partnership and "S" corporation were formerly used.
The LLC may even be used in those circumstances
where the "C" corporation was used. However, the
"C" corporation does have its advantages,
particularly with respect to the availability of
nontaxable fringe benefits and asset protected
retirement plans. Therefore, we recommend you
continue to use the "C" corporation in those
circumstances where a "C" corporation was formerly
used. Use an LLC in those situations were a limited
partnership (including an FLP, unless a specific
estate and gift tax result is desired) or "S"
corporation was formerly used.
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