S Corporation and LLC – Key Differences
- S Corporation restricts who can be a shareholder
- Allocation of Income strictly restricted amongst owners / shareholders of an S Corporation
- Tax – Lack of Ability to increase pass-through losses in an S Corporation
Restrictions on Ownership
- The S corporation limits the type of person or entity that may share in ownership.
- Another C Corporation CANNOT be a shareholder / owner of an S Corporation.
- Certain trusts cannot be an s corporation shareholder.
- An S corporation is limited to 100 shareholders.
A note on filing requirements: Dont forget about state taxes and filings. Most states, however, conform to the IRS requirements and specifications for an S Corporation. Some states, however, do require that a separate S Corporation filng be made at the State level if your corporation is to be considered an S Corporation for STATE tax purposes.
Allocation of Income
One of the major differences of an S-Corp vs an LLC, is that the S Corporation is very strict in terms of allocating income amongst shareholders. Each shareholder shares in the corporation’s income in the same proportion as his/her ownership.
An LLC, on the other hand, is very FLEXIBLE in how it owners / members may allocate income amongst each other. In an LLC, the operating agreement usually states what share of profits each owner is to receive.
Example: Charlie and Heidi sell Chicken Broth
Charlie and Heidi open a chicken broth factory each owning 50%. Charlie is the investor and Heidi does all the work. Soon, the business is more profitable than they had ever imagined. Because Heidi has been working so hard, and because Charlie has been on vacation for the past 8 months, they agree that Heidi should keep 75% of the profits and Charlie should get 25%.
In an LLC, this is not a problem. An LLC is very flexible when it comes to allocation of income amongst owners. Charlie and Heidi simply agree to the arrangement and they will be taxed according to the income allocated in the operating agreement.
In an S Corporation, this is a BIG PROBLEM! In an S Corporation, each owner / shareholder must share in the income in proportion to his/her ownership. Because each is a 50% owner, each will be allocated 50% of the corporation’s income for purposes of computing income tax…regardless of any other agreements between the parties.
S Corporation allows only one class of stock
In an S Corporation, all shareholders own only one class of stock. While it is permissible to designate voting and non-voting shares, a distinction such as common stock or preferred stock is not allowed.
Designating different classes of stock becomes important where different shareholders will begin sharing income differently. In some cases, for example, a preferred stockholder may receive distributions of income (or assets upon dissolution) in first priority, leaving remaining assets, if any, to distributed to common stock shareholders. This scenario is NOT allowed in an S Corporation.
In an LLC, however, these priorities and preferences ARE allowed.
Example: Benny Madlov wants to be a profit partner
“Cash is Us, Inc.” hires Benny Madlov as a salesman to bring in hedgefund investors. Madlov brings in so much business, that he demands a stock options and a share of company profits.
In an S Corporation, there may only be one class of stock. So, if he is to be given shares, they will be of the same class as the other shareholders and he will be taxed (income will be allocated) proportionally according to his share of ownership…not based on his sales performance.
In an LLC, the owners / members have the flexibility to create an agreement that will best motivate Madlov to perform while also providing a level of safety and comfort to the other owners / LLC members.
Income Tax and Pass-through Losses
In certain circumstances, the IRS allows the loss in a corporation or LLC to “Pass-through” to the individual shareholders / members. This loss can then offset other sources of income in effect reducing an individual’s overall tax liability.
For Real Estate owners and investors, these “pass-through” losses can provide an enormous reduction in tax liability.
If you compare an S-Corp vs an LLC, in an S Corporation, there is a lack of ability to increase pass-through losses in real estate. In an LLC, however, there exists an ability to increase pass-through losses.
Real Estate Investments in an LLC
In general, the tax basis for a share in a corporation or LLC is equal to the investment in the corporation or LLC. In an LLC used for real estate investments, however, the members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss.
Example: Ronald Gump: Gump Towers Goes Upside Down
Ronald Gump invests $10 in Gump Towers. The tax basis is $10. Gump Towers mortgages the real estate and borrows $20. Rental income and Values decline leaving Gump Towers with a $20 loss at the end of year one.
Simply stated, Gump has lost $20 through investment activities in real estate.
S Corporation: Because the tax basis for Gump Towers is $10, the IRS will only allow Gump a $10 loss on his personal income taxes. The remaining $10 loss will be deferred.
LLC: LLC members are allowed to add the amount of the mortgage to their basis for purposes of calculating loss. In an LLC, Gump may deduct the entire $20 loss in year one.
LLC Business Structure Comparison Chart
Corporation vs. LLC
To view the following tax forms, you will first need to Download Adobe Reader.
Download IRS Form 2553 S Corporation
Download IRS Form 8832 LLC elects to be taxed as a corporation