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January 23, 2006

The TaxProf Blog has a fine post this morning noting that S corporations remain more popular than LLCs. UM-KC prof Christopher R. Hoyt writes:

Trends in the real world on "choice of entity" decisions may conflict with the recommendations we might make to students. Generally I prefer an LLC to any sort of corporation, but every year there are twice as many S Corporations formed as there are LLCs.

Professor Hoyt's post doesn't discuss why this is happening. My initial thoughts*:

Self-employment and FICA taxes:While the IRS is trying its best to frighten people in this regards, S corporation shareholders still often have more ability to reduce employment taxes than LLC members. S corporation K-1 earnings aren't self employment income, while LLC earnings usually are, at least for active members. The continuing uncertainty over how LLCs are to be treated for self-employment taxes doesn't help.

Complexity: While LLCs have a lot more flexibility than S corporations, many business owners don't want the accompanying complexity. I've seen many eyes glaze over while trying to explain capital account maintenance and liability allocation issues, and I don't think the boredom was all my fault.

S corporation liberalization: Congress has passed a series of laws making it easier to qualify for an S corporation election.

General Utilities issues: A C corporation can often convert to S corporation status at a small tax cost; the ten-year built-in gain tax can often be managed. In contrast, a C corporation cannot become an LLC without immediately recognizing all of its built in gains in liquidation.

W-2 vs. guaranteed payments: S corporation owners take their compensation out of the business as salary, which is reported on form W-2, with the usual tax withholding. LLC members pick up their compensation as guaranteed payments, with no withholding mechanism. Many business owners prefer S corporation salary, with taxes withheld, to paying quarterly estimated taxes on their guaranteed payments.

State Issues: Iowa discriminates against the LLC form for multi-state businesses based here. Iowans owning S corporations get a tax credit that has the effect of applying modified single-factor apportionment to their distributive share. The credit is unavailable to LLC owners.

Regulatory restrictions: There has been a surge of S corporation elections by community banks since 1996, when they first qualified. While banking authorities are beginning to take steps to allow LLC banks, it's not clear that it is even possible for an LLC to be taxed as a bank.

In my practice I see LLCs most often used in the way noted by Mr. Hoyt:

Real estate and finance/insurance account for nearly 75% of the assets of all businesses operating in any sort of partnership form.

I see LLCs and LLPs used a lot in ventures between corporations (including S corporations), real estate deals and investment entities. For other businesses, most owners prefer the perceived simplicity and straight-up income and loss allocations of S corporations.

UPDATE: Russ from Taxable Talk looks at the issue from a California perspective:

In California, there are two major factors working against LLCs. First, all S Corps and LLCs in California must pay a minimum state franchise (income) tax of $800 per year (or 1.5% of net income, whichever is greater). But LLCs also face a gross receipts tax, so LLCs in California are triple-taxed! The current minimum gross receipts tax (called an LLC fee) is $865 per year. Second, some businesses are prohibited from being in an LLC. These include professionals, such as architects and accountants. (They can form LLPs, though).

*For purposes of this discussion, I assume we are talking about LLCs choosing to be taxed as partnerships.

UPDATE, 2/23/06: More here.

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Other positives.

1) The ability to use sec. 368.
2) The very different treatment in bankruptcy (sec. 108).

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