Note: These are only a few of the factors to consider. For a complete analysis of the selection factors in your business, call us at (770 461-1115)

Corporations and limited liability companies ("LLCs") both provide their owners with limited personal liability for debts of the entity. Limiting the ownersÍ exposure to personal liability for liabilities of the entity is usually an important factor in choosing a form of entity for a business. For many new businesses, choosing a form of entity that provides "pass-through" income tax treatment is also desirable. Corporations which elect S corporation tax status (i.e., "S corporations") and LLCs which are taxable as partnerships provide "pass-through" income tax treatment to their owners. Both S corporations and LLCs generally will not be subject to income taxation at the entity level. Instead, the income, loss, credits and deductions of the entity pass through to the owners and are reflected by the owners in determining their income tax liabilities. However, while the tax treatment of S corporations and LLCs is similar, it is not identical. Consider the following issues in determining which form of entity makes better sense in a particular situation:

1. Who Are the Owners of the Entity?

To be eligible to elect S corporation status, a corporation may not have more than 75 shareholders (husband and wife are counted as one shareholder for this purpose). In addition, only individuals (other than nonresident aliens), estates and certain trusts may be shareholders in an S corporation. In addition, beginning this year, pension plans and exempt organizations became eligible shareholders in an S corporation. However, a corporation may not elect S corporation status if it has an ineligible shareholder such as a corporation, partnership, LLC, or nonresident alien.

There are no restrictions as to who may be an owner of an LLC. An LLC will be entitled to pass-through tax treatment as a partnership so long as it is not a "publicly traded partnership." Under recently adopted Treasury Regulations, an LLC with two or more members will be treated as a partnership for federal income tax purposes unless it elects to be treated as a corporation. Note also that if permitted under state law, similar tax treatment accrues to a single-member LLC. (GeorgiaÍs LLC Act allows single-member LLCs.) Under the Treasury Regulations, an LLC with a single member is disregarded as an entity separate from its owner and the income, loss, credits and deductions are reflected by the owner in determining its income tax liability.

2. What Restrictions Govern Allocation of Income and Loss and Distributions Among the Owners?

An S corporation may have only one class of stock, although voting and nonvoting common stock are permitted. Each share of stock must confer identical rights to distribution and liquidation proceeds. Taxable income and loss of the S corporation generally is allocated on a per share-per day basis. Under certain circumstances, debt may be treated as a second class of stock, thereby disqualifying the corporation from S corporation status. A safe harbor is provided for "straight debt" issued by a lender that would be an eligible shareholder in an S corporation or by a lender that is actively and regularly engaged in a lending business.

LLCs offer greater flexibility than do S corporations in allocating income and loss and distributions. These generally will be governed by the Operating Agreement of the LLC. Allocations of income and loss are limited only by "substantial economic effect" regulations. Members can receive "preferred returns" and there can be "flips" whereby the allocation method changes over time. In addition, LLCs provide similar flexibility in allocating distributions among members or classes of members.

3.What Effect Does Debt Incurred by the Entity Have on an OwnerÍs Basis?

A shareholder in an S corporation receives basis only for indebtedness of the S corporation to the shareholder. A member in an LLC, however, may include an allocable share of all LLC indebtedness in the basis of its LLC interest. For both S corporations and LLCs, deduction of losses is limited to the ownerÍs basis in its interest. Therefore, increased basis may permit deduction of more losses. For both S corporations and LLCs, distributions of cash in excess of basis are taxable gain. Increased basis therefore may permit tax-free distribution of loan proceeds. This makes LLCs particularly advantageous for real estate investments. As the value of the LLCÍs property increases, the LLC may refinance the property and, because the members receive additional basis for LLC debt, the LLC potentially may distribute the proceeds tax-free to its members.

4.What is the Tax Consequence of the Contribution of Appreciated Property to the Entity in Exchange for an Interest?

Property generally may be contributed to an S corporation in exchange for stock in a tax-free transaction provided that immediately after the exchange the transferor or transferors own stock possessing at least 80 percent of the voting power of the stock entitled to vote and at least 80 percent of the shares of nonvoting stock, if any. Property generally may be contributed to an LLC for an interest in a tax-free transaction without regard to any 80 percent control test. The contribution of property to the entity in connection with its formation generally should be tax-free for the owners of either an S corporation or LLC. However, if subsequent to its formation, an S corporation will be acquiring property in exchange for issuing additional interests, the 80 percent control requirement for nonrecognition of gain may be violated and thus this requirement is an impediment for some S corporations.

When property is transferred to either an S corporation or an LLC in exchange for an interest, the entityÍs basis in the asset will be the same as the basis the transferor had in the asset. If the entity sells the asset, it will recognize gain or loss. If the asset was appreciated in value at the time of its contribution, the asset will have a built-in gain that may be recognized by the entity at the time the asset is sold. A special rule applies to LLCs whereby this built-in gain (or built-in loss), when recognized by the LLC, would be allocated to the contributing member. This prevents a shift of taxable income or loss to other members. No similar rule applies to S corporations.

5.What is the Tax Consequence of the Distribution of Appreciated Property by the Entity to an Owner?

Gain is triggered when an S corporation distributes appreciated property to its shareholders as though the corporation had sold the property to the distributee for fair market value.

However, in contrast, appreciated property generally may be distributed to LLC members tax-free. (Exceptions: (1) where appreciated property is contributed to an LLC and distributed to another member within seven years, the contributing member must recognize gain in the amount of the appreciation in the property at the time of its contribution and the distributee receives a corresponding adjustment to the basis in the distributed property; (2) with certain exceptions, distributions of marketable securities are treated as distributions of money and thus to the extent the value of such distributed marketable securities exceeds the distributee LLC memberÍs basis in the LLC interest, the member would recognize a taxable gain.)

6.Are Adjustments to the EntityÍs Basis in Its Assets Possible When a Member Sells or Transfers an Interest in the Entity?

When a shareholder in an S corporation sells shares for a gain or shares are transferred upon a shareholderÍs death, the transfereeÍs basis in the shares is equal to (1) its cost in the case of a sale or (2) the fair market value of the shares in the case of a transfer of shares on death. However, the corporationÍs basis in its assets remains unchanged and the full amount of gain must be recognized when the corporation subsequently sells assets which have appreciated.

LLCs may make an election under IRC Û 754 to adjust the basis in the LLCÍs assets when an interest in the LLC is sold or is transferred upon the death of a member. This election prevents double taxation of appreciation. For example, if a member sells its interest for a profit (attributable to appreciation of the LLCÍs assets), the member will recognize gain. A Section 754 election would allow the LLC to increase the basis in its assets by that amount of gain and thus prevent the gain from being taxed again when appreciated assets are sold (and with respect to depreciable property, the election permits higher depreciation deductions). Note, however, the Section 754 election can be disadvantageous if assets have depreciated in value.

7.Can the Entity Be Acquired by Another Entity in Exchange for Stock or Other Ownership Interests on a Tax-Free Basis?

LLCs and S corporations also receive different treatment here. The tax-free reorganization provisions of IRC Û 368 are applicable to S corporations; thus, the S corporation can be acquired in exchange for stock in an acquiror corporation on a tax-free basis. In a tax-free reorganization, an S corporation can be merged into another corporation with the shareholders of the S corporation receiving stock of the acquiror; the shareholders of the S corporation can exchange the stock of the S corporation for voting stock of an acquiror; or the S corporation can exchange substantially all of its assets for voting stock of an acquiror, which is then distributed in liquidation to the S corporationÍs shareholders.

An S corporation cannot be merged into an LLC on a tax-free basis. The exchange of stock in the S corporation for interests in an LLC is a taxable exchange. It may be possible to structure a transaction in which an LLC acquires assets of an S corporation in exchange for interests, but the S corporation must remain the owner of those interests. A distribution of the LLC interests to the S corporation shareholders would trigger recognition by the corporation of any gain on the LLC interests.

The tax-free reorganization provisions of IRC Û 368 which allow tax-free mergers of corporations do not apply to LLCs. An exchange of LLC interests or assets for stock will be a taxable transaction unless the transferors of the LLC interests or assets receive stock which gives them at least 80 percent control of the acquiring corporation. It may be possible, however, to merge an LLC into another LLC in a tax-free transaction. Because the tax-free reorganization provisions do not apply to LLCs, business owners who expect that their exit strategy will be an acquisition of their business by a public company in exchange for stock may prefer organizing as an S corporation rather than an LLC. It may be possible to incorporate an LLC on a tax-free basis (as an exchange of property for stock representing at least 80 percent control of the issuing corporation) prior to a tax-free reorganization. However, in order for the incorporation of the LLC to be respected by the IRS as a tax-free transaction, a sufficient period of time must pass between the incorporation of the LLC and the reorganization transaction.

8.How Are Sales of Interests Taxed?

Gain or loss from the sale of stock in an S corporation generally will be capital gain or loss. Losses (up to $100,000 for husband and wife filing a joint return) derived from the sale of S corporation stock may be treated as ordinary loss under IRC Û 1244.

Gain or loss from the sale of interests in an LLC generally will be capital gain or loss. However, gain or loss attributable to a memberÍs share of the LLCÍs unrealized receivables (including for this purpose, depreciation recapture) and inventory is treated as ordinary income or loss.

9.How Are the Entities Treated for State Income Tax Purposes?

Georgia and most other states generally follow the federal treatment for both S corporations and LLCs. Several states subject S corporations to income tax at the corporate level: Louisiana, Massachusetts (for "large" S corporations and business trusts), Michigan, New Hampshire, Tennessee and Texas. Texas imposes an income-based franchise tax on LLCs. Two major states recently changed their income tax laws relating to LLCs. Beginning January 1, 1998, LLCs characterized as partnerships for federal income tax purposes are no longer subject to Pennsylvania corporate income tax. Beginning July 1, 1998, LLCs characterized as partnerships for federal income tax purposes are no longer subject to Florida corporate income tax.

10.How Are Owners Treated for Social Security Tax Purposes?

Under proposed regulations, managers (of manager-managed LLC), members (of member-managed LLCs), and other members who participate in the LLCÍs business for more than 500 hours during the year may be subject to self-employment tax (Social Security and Medicare taxes imposed on self-employed individuals) at 15.3% on their distributive share, whether or not distributed, of the LLCÍs income derived from the LLCÍs trade or business (other than certain investment or rental income). It is important to note that only the Medicare portion (at 2.9%) of the tax is imposed once the taxpayer has wages and self-employment income equal to the Social Security wage base ($68,400 in 1998). Under current law, S corporation shareholders are not subject to Social Security taxes on S corporation income. However, where shareholder-employees do not receive adequate compensation for services and receive distributions from the S corporation with respect to their stock, the IRS may re-characterize some or all of the distributions as compensation for services which is subject to Social Security tax.

A noncode provision of the Taxpayer Relief Act of 1997 (P.L. 105-34) provides that no temporary or final regulation with respect to the definition of a limited partner (and thus the imposition of self-employment tax on members in a limited liability company) may be issued or made effective before July 1, 1998 (Act Sec. 935 of P.L. 105-34). According to the Sense of the Senate regarding this provision, Congress, not the Treasury Department, should determine the tax law governing self-employment income.

11.Is It Easy to Shift from an LLC to an S Corporation or from an S Corporation to an LLC?

An LLC generally can be converted into a corporation without imposition of tax and can then elect S corporation status. On the other hand, conversion of an S corporation into an LLC generally will result in a shareholder-level tax on any appreciation in the S corporationÍs assets. The S corporation must recognize gain or loss as though it had sold its property to the distributees for fair market value. The gain, if any, passes through to and is taxable to the shareholders and increases their bases in their stock. Although the amounts received by the shareholders in liquidation are treated as made in payment in exchange for the stock, there is not a second tax because the shareholdersÍ bases have been increased by the corporationÍs gain.

12.Is There a Better Choice That Applies in All Cases?

Unfortunately, there is no better choice that applies in all situations. In many cases, especially in a real estate business, the flexibility in ownership of interest and allocations, the treatment of LLC debt, and the availability of the Section 754 basis adjustment election will make the LLC alternative clearly preferable. In other cases, such as where the exit strategy involves an acquisition by a public company, the S corporation alternative is preferable. The decision is generally made by the client after evaluating the importance each of the differences in treatment and will be based on the clientÍs particular facts and circumstances.