LLC better than S Corps?

The LLC has a number of advantages over an S corporation, as outlined below.  However the S corporation has a significant advantage over the LLC.  That is, shareholders of an S corporation can reduce or eliminate their self-employment tax on their distributive share of income of the S corporation.  The manager of the LLC cannot.  This is the principal reason a business may choose a S corporation over an LLC.

Number of Owners

An S corporation may have only 75 shareholders, while an LLC may have an unlimited number of members.  However, an S corporation may be preferred for one-person companies in states that do not allow one-member LLCs.

Types of Owners

Shareholders of S corporations are limited to individuals, estates, financial institutions, tax-exempt qualified retirement trusts, tax-exempt charitable organizations and certain types of trusts.  Corporations, LLCs, partnerships and most types of trusts  and non-resident aliens cannot be shareholders of an S corporation.  There are no restrictions on eligibility for LLC membership.

Special Allocations

An LLC may make special allocation of income deductions, and gain and loss items if the allocation has substantial economic effect.  An S corporation may not make special allocation to shareholders.  Because of the one-class-of-stock rule for S corporations, the items of income, gain, loss, deduction and credit of an S corporation cannot be separately allocated to a particular shareholder.  Instead, they are taken into account by all of the shareholders on a per-share, per-day basis.

Ownership Interests

LLCs may issue different classes of ownership interest.  An S corporation may issue only one class of stock.  Advances to shareholders of an S corporation, or buy-sell agreements among shareholders may create a second class of stock that disqualifies the S election.  The LLC has no such restrictions.

Borrowings Increase Basis

S corporation shareholders and LLC members may deduct company losses on their individual tax returns to the extent of their basis.  LLCs, however, may increase the basis of their membership interests when the LLC borrows money.  S corporation shareholders may not increase the basis of their stock when the corporation borrows money or when the shareholder guarantees a corporate loan.  An S corporation shareholder may only increase his basis by making a direct loan to the corporation.

Distribution of Refinancing Proceeds

It is easier to distribute the proceeds of refinanced property in an LLC than in an S corporation.  In both cases, distributions are normally taxed to the extent that the cash distributed exceeds the owner's basis in the company.  In an LLC, loans increase a member's basis in the LLC  The proceeds from cash borrowings against LLC property can usually be distributed to members without tax because of the basis increase when the money is borrowed against LLC property.  In an S corporation, the cash proceeds from refinanced loans are more likely to result in a tax to shareholders.

Distributions of Appreciated Property

The distribution of appreciated property by an S corporation to a shareholder is treated as a taxable sale of the property.  This rule applies to dividends, redemptions of shares, and liquidations.  The gain equals the difference between the fair market value of the property and the LLC's adjusted basis in the property.  The gain passes through and is taxable to the shareholders on a per-share, per-day basis and increases the shareholder's adjusted basis in his shares.  The shareholder who receives the distribution then reduces his basis by the fair market value of the distributed property and receives a fair market value basis in the property.  The LLC, by contrast, does not treat the sale of appreciated property to a member as a taxable sale.  There is no tax unless the money distributed exceeds the member's basis in the LLC interest, or the LLC makes a disproportionate distribution of unrealized receivables or substantially appreciated property.

Other Tax Benefits

LLCs are not subject to certain penalty taxes that apply to S corporations that were formerly C corporation, such as the built-in gains tax and the excess passive income tax.  An S corporation may not adjust the basis of its assets upon the death of a shareholder or the sale of stock by the shareholder.  An LLC may elect to step up the basis of its assets upon the death of a member of the sale of a membership interest.  Therefore, if a shareholder in an S corporation dies, the heirs will receive a step-up in basis for the stock.  If the corporation thereafter sells appreciated assets, the gain will flow through and be taxed to the inheriting shareholders even though the appreciation occurred before the shareholder's death.  The same problem arises for the person who purchases stock in an S corporation that has appreciated assets.

The S corporation has advantages of the LLC in certain cases.  A C corporation may obtain pass-through tax treatment by converting to an S corporation.  The conversion does not result in taxation of appreciated assets or other adverse tax consequences, subject to four main exceptions.  A C corporation may also obtain pass-through tax treatment by converting to an LLC.  However, the conversion is usually taxable.  It is treated as a liquidation of the corporation, taxable both to the corporation and to its shareholders.

A second advantage of the S corporation is the tax-free rules for mergers and other reorganizations that apply to S corporations.  For example, an S corporation may merge into a C corporation on a tax-free basis.  Similar rules do not apply to combinations of LLCs and other corporations.