LLCs vs. S Corporations:
The nature and number of owners can impact which entity choice is preferable. The following are points to keep in mind when the choice has come down to either an LLC or an S Corporation:
- LLCs—there are no limits on the type or number of owners in an LLC. Thus, corporations for example, can be LLC owners.
- S Corporations—there are limits on the type and number of owners in an S corporation. There can be no more than 100 owners, although family members are counted as one owner. There can be no nonresident aliens as owners; only U.S. citizens and residents are permissible S corporation shareholders. There can be no corporations or partnerships as owners.
Which Entity is the Best Choice for Businesses Involving Real Estate Investments?
Owners can write-off business losses passed through to them from the business only to the extent of “basis.” The term has different meaning for purposes of LLCs and S corporations.
- LLCs—basis is the owner’s capital investment in the business and his or her share of the business’ debts. For example, if the business borrows $100,000 to buy property and there is one LLC member, he or she can add this $100,000 to basis.
- S Corporations—basis is the owner’s basis in stock (what he or she paid for the stock) plus basis in debt (what he or she loaned to the corporation). Third-party loans to the corporation do not increase the owner’s basis. Third-party loans to the corporation that the owner guarantees become part of basis only when and to the extent the owner must make good on the guarantee.
For businesses involving real estate investments, the LLC provides a greater basis advantage.
Which Entity is Best for Owners Who Work for their Business?
Employment taxes are an important consideration for business owners. Owners should not only be concerned with income taxes; they should also consider the impact of entity choice on Social Security and Medicare taxes.
- LLCs—owners are self-employed individuals subject to self-employment tax (which covers both the employer and employee share of FICA for Social Security and Medicare taxes). As a general rule, owners must pay self-employment tax on their share of net earnings from the business.
- S corporations—Shareholders who work for their business are employees. FICA is imposed only on wages paid to these owners. While there may be a temptation to pay no wages since the owners reports their allocable share of net income from the business without SE tax, the IRS has consistently help that owner employers must receive (and pay FICA on) a reasonable amount of compensation based on the fair market value of the work performed for the Corporation. Making sure that S corporation owners do not skirt this requirement has become a key audit consideration of the IRS.
For owners who work for their business, there may be less employment tax cost with an S corporation.
What Do I Need to Know About Raising Capital?
In theory, if you want to borrow money for a start-up or take in investors, there should be no difference between these entity choices. However, in practice, the Corporation may offer an advantage—this type of entity has been around longer, so potential lenders/investors are more familiar with and prefer to deal with Corporations. It’s important to keep in mind what you foresee for your business. If it includes going public or taking on a large number of new owners, the C Corporation may be the better choice for now.