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What are the Benefits of an LLC Over an S Corporation
in Nevada?
Last updated Sunday, April 7, 2024
With the passing of the check-the-box-Regulations at the end of
1996, LLCs now can enjoy limited liability, centralized management, free
transferability of interests, and continuity of life, and still be taxed as
a partnership Federally!
Around the same time as the check-the-box regulations were being
put in place S corporations’ rules were being revised. There were 17 statutory
amendments enacted by Congress as part of the Small Business Job Protection Act
of 1996. The Sub S amendments were intended to promote similarities between the
S corporation and partnerships. For example, now S corporations can have up to
75 shareholders and an S corporation can own any percentage of stock in a C
corporation (remember a C corporation, LLC or LP can not be the stockholder of
the S corporation). That is why it is so hard to protect the S corporation
stock).
Example 1: It is ok for an S corporation to own Stock in a
Corporation.
Example 2: It is NOT ok for an S corporation stockholder to
be a C corporation Sec.
1361 (b)(1)(B).
*A Term LLC will dissolve at a predetermined date, i.e. 30 years
from the date of formation. An at-will LLC will dissolve under basic
partnership rules.
Because of these changes, we need to reanalysis the S corporation
compared to a C corporation.
Let’s examine the following areas of differences between S
corporations and LLCs:
1. State
Law Differences
2. Eligibility
Limitations
3. Multi-Tiered
Structures
4. Tax
Rates
5. Certainty
of Tax Status
6. Tax-Free
Formation Issues
7. Equity
Interests Received For Services
8. Entity-Level
Taxation
9. Use
of Cash Methods
10.Debt-Basis
Issues
11.Distributions
12.Sales
or Exchanges of Equity Interests
State Law Differences
A corporation C or S is organized under a governing state
statue pursuant to its corporate charter. All corporations start out as C
corporation then have to make an election within 75 days to become an S
corporation, form 2553. The corporate charter generally requires the disclosure
of the following:
1. The
corporation’s purpose
2. Incorporators
of the corporation
3. Place
of the Resident Agent
4. Initial
Board of Directors
5. Classes
of Stock
Following the filling of the articles of incorporation, the Bylaws
are adopted. Minutes and meetings are held and stock is then issued. Buy-sell
agreements may then be put in place to handle the death of one of stockholder.
A corporation has limited liability to its owners, has centralized management
though the board of directors, and exists perpetually until it either becomes
bankrupt or is liquidated and dissolved by the vote of a majority of its
shareholders.
An LLC is also a creature of the state. It has the best of both
worlds of a corporation and a limited partnership. In the past you had to be
careful not to have two or more of the corporate characteristics so you would
be taxed as a partnership. Now, with the check-the-box rules you do not have to
worry about that. So the LLC allows much more
flexibility in its drafting. Much of this flexibility comes from the operating
agreement.
Despite this difference with an S corporation and LLC, the states
basically provide the same limited liability for shareholders of an S
corporation as with members of an LLC.
Conclusion: State law should be considered a neutral
factor in comparing multiple-member LLCs to S corporations. The single
member LLC is recognized in 21 jurisdictions and may afford less
protection from unlimited liability to its owners. In contrast, the
single-shareholder S corporation still insures limited
liability (this assumes the corporate veil will not be pierced. That is another
advantage of Nevada because it is the most difficult state in the country in
which to pierce the corporate veil).
Eligibility Limitations
There is no limitation on the number of investors who can
participate in an LLC taxed as a partnership. The exception is a publicly
traded partnership provisions under Section 7704, which recast a pass-through
entity under state law into an "association" for federal income tax
purposes.
Even though 21 states allow single member LLCs, most states do
not. A challenge comes about when you form an LLC in a state that allows one
person LLCs and then you have to register to do business in a state that does
not recognize one person LLCs. This is all despite the fact that the –box rules
allow a single person LLC.
Subchapter S corporations have always capped the number of
stockholders to its present-day number of 75. Spouses (and their estates) are
considered to be one shareholder Sec. 1361 (C)(1).
The next area to compare is who can be eligible to be equity
participants. Since any individual or entity, foreign or domestic, can be a
member of an LLC, the LLC has substantial advantages over the S corporation.
The S corporations are subject to rigid rules as who can be owners. As we
already mentioned, LLCs, corporations, LPs, and certain trusts can not be
owners of S corporations. Only a grantor trust, qualified Subchapter S trust
(QSST), or the new electing small business trust (ESBT).
Now, let’s compare the limitations on use of debt/equity. Since
S corporations only have one class of stock, LLCs have an advantage. An S
corporation can not provide a liquidation or distribution preference to a
shareholder. Even a buy-sell agreement must be carefully drafted as not to
provide a second class of stock Reg. 1.1361-1(l). In other words, you cannot
draft a buy-sell agreement to circumvent the single-class-of-stock requirement
and the agreement establishes a redemption or purchase price which, at the time
the agreement was entered into, was significantly below or in excess of the
stock’s FMV Reg.1.1361-1(l)(2)(iii). This regulation basically says agreements
to redeem or purchase stock upon the death, divorce, disability termination of
employment is disregarded under the single-class-of-stock analysis. An S
corporation can issue or enter into the following types of securities or
arrangements without placing its pass-through status at risk:
1. Qualified
straight debt-Sec 1361 (c)(5). This basically means a debt that is
written and unconditional obligation to pay a sum certain in money with
interest rate and payments dates not conditioned on the borrower’s profits or
discretion and which is not convertible directly or indirectly into stock. The
holder must be an eligible shareholder; there are exceptions after 1996 on
this.
2. Nonvoting
common stock- Sec 1361(c)(4).
3. Equity-type
arrangements not resulting in the issuance of stock, including
options (other than "in-the-money"), phantom stock or stock
appreciation rights-Reg. 1.1361-1(b)(4).
4. A
joint venture or other business arrangement with persons otherwise unable to
own stock in the S corporation directly- Reg. 1.1361-1(l)(4)(ii)(A)(2).
By contrast LLCs and partnerships can issue multiple classes of
equity interests, create distribution and liquidation preferences, provide for
special allocation of tax items (within the boundaries of Section 704), and
issue equity-flavored debt.
Multiple-Tiered Structures
An LLC or LP can be itself a member or partner of other LLCs or
LPs. Multiple tiered structures allow for protection against creditors and
separation of business assets. A typical situation may look like this:
Until the 1996 Act, S corporations were greatly disadvantaged in
this area. For example an S corporation could not own
80% of the value of stock of another corporation. Now, the 1996 Act permits
an S corporation to own any percentage of stock in a C corporation.
These S corporations’ structures have limitations unlike C corporation’s
structures.
For example, dividends paid to the parent S corporation are ineligible
for a dividends-received deduction and other transactions are excluded from the
application of consolidated return rules.
Tax Rates
From a federal income tax standpoint, an LLC member who is an
individual and the shareholders of S corporations are equally subject to the
maximum marginal rate of 39.6%. By contrast, the maximum rate of federal income
tax on a C corporation is 35%. Can you see how with an LLC there may be a tax
advantage to have a C corporation as the member?
There is however, a slight advantage for shareholders in S
corporations in the employment tax area. The combination of FICA, FUTA and
Medicare taxes for employee shareholders of an S corporation is 15.3% of the
first $76,200 of wages-Rev.Rul. 59-221, 1959-1CB 225. By setting a
reasonable salary, a shareholder of an S corporation can avoid paying
the additional Medicare taxes of 2.9% on the distributive share of income from
the S corporation. According to Sandy Botkin, he recommends taking a salary
of about 50% of the S corporation’s net profits. So, if the S corporation has
net earnings of $100,000 at years end, $50,000 should be salary subject to
payroll taxes.
For partnerships it is different. Under Section 1402 (a), an
individual partner’s net earnings form self employment, also taxed at a rate of
15.3%, includes the individual’s distributive share of partnership
income (exceptions are for rental income, section 1402 (a)(1), interest
and dividends Section 1402 (a)(2), and capital gains and losses 1402 (a)(3).
What does this mean? If you have rental property or investments in an LLC
that income will not flow though to you subject to self-employment
taxes! Keep in mind a limited partner’s receipt of a guaranteed payment
for services is within the self-employment tax base.
The main question for an LLC is whether the member is a limited
partner or not! Prop. Reg. 1.1402(a)-2 provides an investor in a
pass-through entity, including an LLC, will be a limited partner for
self-employment tax purposes unless such individual:
1. Is
personally liable for entity debts by reason of being a partner or member,
2. Has
authority to contract on behalf of the entity under state law or the governing
instrument, or
3. Participates
for more than 500 hours during the tax year in the entity’s trade or business.
So if you have the authority
to bind the LLC, liable for the debt and work more than 500 hours per year you
will be subject to SE taxes. SEE pages for more detail on SE taxes.
Certainty of Tax Status
Despite the reforms with the S corporations’ shareholders, great
efforts must be followed to not lose the S status. Once lost, an S corporation
can not re-elect S status for five years. In contrast with the check-the-box
rules, the tax status of an LLC as a pass-through entity is simple to establish
and maintain. The advantage clearly goes to the LLC in this category.
Tax-Free Formation Issues
Assets can be transferred to a corporation tax-free under Section
351 provided the transferors control the corporation. Section 368 (c) defines
control for purposes of ownership to be at least 80%. So, if you transfer an
asset to an S corporation and you want it to be tax-free you must take back 80%
of the stock. If you are transferring an asset that has a greater debt than
basis (mortgage over basis), the excess above the basis will result in a
taxable gain.
Example: You have a rental property with a FMV of $150,000. It has
a basis of $50,000 and a mortgage of $75,000. Under Sec. 351 you could transfer
it to the S corporation. Since there is a mortgage over basis of $25,000, you
would pay personal income tax on that $25,000.
In an LLC, when you transfer assets tax-free into that falls under
Section 721. These are the partnership rules for tax-free transfers.
They are very similar to the corporation.
Equity Interests Received for
Services
When a member of an LLC receives a membership interest in exchange
for services, the transfer falls outside of Section 721. The value of the
capital interest is treated as a guaranteed interest and is included in gross
income. Section 707 (c) and Reg. 1.721-1(b)(2).
This immediate taxation can be avoided if the members contribute
property or capital to the LLC. It may be each member contributing as little as
$500 for his or her interest in the LLC.
In an S (and C) corporation, the receipt of stock for services is
taxable to the recipient provided the stock is nonforfeitable or transferable
–Sections 83 (a) and 1032 (nonrecognition for exchange of a corporation’s own
stock). A corresponding deduction is allowed to the corporation- Section 83 (h)
and Reg. 1.83-6.
Entity-Level Taxation
The LLC is not subject to federal income tax unless it
affirmatively elects to be taxed as an association. Also, single member LLCs
are also ignored for federal income tax purposes unless the owner opts to be
taxed as a corporation. Some states have a franchise tax on LLC income, most
states do not. The LLCs tax year generally must conform to that of the majority
in interest of its members- Section 706 (b).
The tax year of an LLC will close on a termination or sale of 50%
or more of the equity interests within a year. It will also close with respect
to a withdrawing member who sells, exchanges, or liquidates his entire
interest.
The tax year of an S corporation may be closed in the event of the
complete termination of a shareholder’s interest or where a certain percentage
of its stock is sold over a certain period – Section 1377(a)(2); see also Reg.
1.1377-1(b). S corporations are generally not subject to corporate income
taxes. The exceptions to non-entity level taxation are applicable to former C
corporations that convert to S status. For example, under Section 1374 on net
built-in-gains recognized during a ten-year post-C-to-S conversion period,
there is a corporate tax imposed.
Another example would be a C corporation converting to S status is
required to recapture the LIFO-FIFO spread over a four-year period-Section 1363
d. The S corporation’s tax year generally must be a calendar year or one that
is the same as its principal shareholders- Section 1378.
Use of Cash Method
Typically, an LLC is not permitted to use the cash method of
accounting- Sections 446 (c) and 448 (a). This is based upon the definition of
"tax shelter" in Section461 (I) (3). The IRS however, issued several
rulings permitting an LLC to use the cash method where;
1. The
LLC did not expect to generate losses,
2. The
members practiced in the profession in which the LLC was engaged,
3. The
LLC was not formed for a tax-avoidance purpose
4. The
interests in the LLC were not syndicated, and
5. The equity
partners managed the entity (see Ltr. Ruls. 9321047).
The S corporation on the other hand has no limitation to the type
of accounting method it chooses. An S corporation can not adopt the cash method
if it is a "tax shelter". Of course, where inventories are used, the
accrual method must be adopted unless the IRS permits otherwise- Reg.
1.4446-1(e)(1).
Debt-Basis Issues
A shareholder of an S corporation can increase his or her
basis by the following ways:
1. By
the amount of funds or basis of property contributed to the capital of the
corporation.
2. By
the amount of funds advanced to the corporation in the form of a loan- Section
1366(d).
An S corporation shareholder can NOT add to stock basis any
indirect contributions, such as the amount of corporate indebtedness,
even if its repayment has been personally guaranteed by the shareholder, unless
the guarantor has made an "actual economic outlay." Basically, did
the shareholder have to put up some money or just a personal guarantee?
Each shareholder of the S corporation is subject to the at-risk
limitation rules under Section 465. This means that loss allocated to a
shareholder may be deducted only to the extent that the shareholder is ‘at
risk’ unless they are exempt from the ‘at risk’ rules. If there is losses in excess of what the shareholder has ‘at risk’
they are suspended and carried forward to the next year to be offset against
income allocated to the shareholder at that time.
Another limitation to shareholder losses is the passive
activity loss rule of Section 469. C corporations are exempt from the
passive activity rules. Each shareholder must determine to what extent they
have participated in activity conducted by the corporation. Everyone would love
to have passive income, because it is not subject to payroll taxes. Here are
the tests to determine if an activity is active:
1. The
individual participates for more than 500 hours during the taxable year.
2. The
participation is the same as all the other participant during the year.
3. The
individual participates for more than 100 hours, but not less than any other
individual.
4. The
activity is a ‘significant participation activity’ and the individual’s
cumulative number of hours or participation exceeds 500 hours.
5. The
individual materially participated in the activity five of the ten years
immediately preceding taxable years
6. The
individual is a service activity and the individual materially participates in
any 3 preceding years.
If you worked at something for less than 100 hours and someone
else works 200 hours your income would be considered passive. This could be
offset by your passive losses.
Members in an LLC are permitted to increase basis in their
interest for their allocable share of entity level debt in accordance with the
Section 752 Regulations. This is not true for S corporations.
Then we have to address the terms ‘recourse’ and ‘nonrecourse’
debt. If an LLC acquires a piece of property and subject to the existing debt
(meaning no member has any liability for it) that would be called ‘nonrecourse’
debt to the LLC. The unique thing about nonrecourse debt is that it can be
allocated to member’s basis disproportionately to their percentage of
ownership. For example, if two people are members of an LLC 50/50. The LLC
purchases a piece of property with debt without the members having to be liable
for the debt. Let’s say the debt is $100,000, instead of distributing it
$50,000 to each partner, you can distribute $20,000 to one partner and $80,000
to another partner!
If an LLC purchased a property and each member personally
guarantees the debt, then it is recourse debt to the LLC and its
members. If in the above example the debt of $100,000 were recourse, then it
would have to be split up 50/50.
The ‘at-risk’ rules also apply to members of an LLC. Usually, most
debt of the LLC is nonrecourse. No member will be able to include it in basis
for ‘at-risk’ purposes. There is an exception, an LLC member who personally
guarantees a debt of the entity will be ‘at-risk’ where his S shareholder
counterpart may not be (remember a personal guarantee does not increase basis
in the shareholder of an S corporation).
Also, if real estate is secured by nonrecourse debt, the LLC
members can qualify for their share of the debt, under the ‘at-risk’ exception
in Section 465 (b)(6)., which is not applicable to S shareholders.
Distributions
For an S corporation without earnings or profits, distributions
are treated first as a nontaxable return of capital to the extent of the
shareholder’s stock basis, and then as a gain from the sale or exchange of
property (Code Sec. 1368(b), Reg. § 1.1368-1(c)).
For a corporation with earnings and profits, unless
an election is made, distributions are treated as follows:
1. a
nontaxable return of capital to the extent of the corporations
"accumulated adjustments account" (AAA);
2. dividends
to the extent of the S corporation’s accumulated earnings and profits
3. a
nontaxable return of capital to the extent of the shareholder’s remaining stock
basis, and
4. gain
from the sale or exchange of property (Code Sec. 1368(C), Reg. § 1.1368-1(d)).
Before applying these rules, the shareholder’s remaining stock
basis and the AAA are adjusted for the corporate items passed through from the
corporate year during which the distributions are made.
The accumulated adjustments account is used to compute the
tax effect of distributions made by an S corporation with accumulated earnings
and profits.
If a C corporation converts to an S corporation, and if the
distribution of corporate property has appreciated while it was in the C
corporation, the built-in gain at the date of conversion will be subject to
corporate-level tax under Section 1374. Distributions of loss property do not
result in the recognition of loss.
For LLCs, the tax treatment of distributions under Subchapter K
will generally be more favorable than the results under Subchapter S,
especially with respect to distributions of appreciated property!
No gain or loss is recognized by the LLC for distributions of
appreciated property. But with an S corporation the distribution will be
taxable!
If property is distributed within a five-year period of being
contributed to the LLC there are some special rules- Section 737. This
applies when a partner contributes appreciated property to a partnership and,
within five years of the contribution, property is distributed back to the
contributing partner. If the value of the distributed property exceeds the
distributee’s basis in his partnership interest, and if the partner continues
to hold the property, the distributee partner will recognize the gain equal to
the lessor of:
1. the
excess of the value of the property distributed over the distributee’s
partnership basis or
2. the
net precontribution gain of the distributee-partner in accordance with Section
704 (c) (1)(B).
Cash distributions in excess of basis are taxable. The other main
point is that any type of distribution in excess of your basis is taxable. The
goal is to have a high basis in your LLC interest. This can be accomplished by
adding debt to the LLC, which was mentioned earlier.
Sales or Exchanges of Equity
Interest
When a shareholder of an S corporation sells part of all of his or
her stock to a third party, the transaction generally will result in capital
gain or loss. Unlike LLCs and partnerships, shareholders of S corporations are
permitted to exchange shares of stock with other shareholders in one or more S
or C corporations pursuant to the requirements of the tax-free reorganization
rules in Section 368.
Where an LLC member sells or exchanges the interest in the LLC,
gain or loss is determined under Section 741 and generally results in capital
gain or loss. If an LLC sells the entire interest, the LLCs year will close on
the date of the sale-Section 706 (C) (2)(A). Also, installment sale reporting
is not available to the extent that the selling member’s share of any
underlying assets of the LLC would be ineligible for installment reporting-
Section 453 (I).
Are You Subject to Self-Employment
Taxes on
Distributions at the End of the Year of an LLC?
The Internal Revenue Code imposes a self-employment tax on a general
partner’s distributive share of income from the partnership’s trade or
business. Code Sec. 1401 and Code Sec. 1402. In contrast, the distributive
share of a limited partner is generally excluded from the
self-employment tax, except to the extent that this share is
a "guaranteed payment" (Code Sec. 1402(a)(13). Pursuant to Code Sec.
707 (c), a "guaranteed payment" is an amount paid to a partner
for services actually rendered to or on behalf of the partnership without
regard to the income of the partnership. It is considered as made to one who is
not a member of the partnership, and is thus subject to the self-employment
tax). Limited partners are exempted from the self-employment tax
rule under the theory that they are more passive investors than true partners
are.
In review, here is the general partner of the LLC (which would be
the manager of the LLC or the member that resembles the characteristics of a
general partner)’s tax situation;
1. A general
partner’s distributions are subject to self-employment taxes,
and
2. Guaranteed
payments are subject to self-employment taxes.
Here are the tax ramifications of a limited partner:
1. Limited
partners are exempt from self-employment taxes, and
2. Guaranteed
payments are subject to self-employment taxes.
The IRS realized that the distinctions for general and limited
partners worked fine for Limited Partnerships, but in the world of LLCs, the
laws didn’t distinguish between the two. Something else had to be done.
The IRS set new proposals for all entities taxed as Limited
Partnerships. They now have a proposed legislation of the definition of a
Limited Partner under Code Sec, 1402(a)(13), which may be made effective before
July 1, 1998. Under the proposed regulation here is the definition of a
limited partner:
A limited partner would be any person classified as a partner
unless they:
1. Had
personal liability for the debts or obligations of the partnership by reason of
being a partner (called the liability test),
2. Had
authority to enter into contracts on behalf of the partnership (called the revised
management test), OR
3. Participated
in the partnership’s trade or business more than 500 hours annually (called the
participation test).
These so-called "functional tests" make it clear that
the distributive share of non-managing members of an LLC will not be
subject to SE (self-employment tax).
Although many do not like this proposed expanded definition of a
limited partner, the final result is right around the corner. The reason the
expanded definition is largely unwelcome due to the concern it will cause for
more record keeping as well as imposing new taxes on partners.
Nevada
Commercial Registered Agent
Entity # E0502742015-6
NV Business ID NV20151637034
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Revised April 7, 2024 10:24 AM
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