How should you incorporate? Comparison of LLCs and S-Corporations.

Subject: Comparison of LLCs and S Corporations

Introduction

      The two most viable entities for most start-up businesses are S corporations and limited liability companies (“LLCs”). Both S corporations and LLC allow flow-through tax treatment to their owners and eliminate double taxation on profits and gains. Although no one characteristic makes one entity superior over the other, this outline examines some of the significant differences that come into play in the formation and operation of S corporations and LLCs.

Formation Issues

Costs

      LLCs: An LLC does not have to pay an $800 California franchise tax on formation, but an $800 minimum tax is due on the 15th day of the fourth month following the date of formation and on April 15 of each year thereafter. The gross receipts fee ( see discussion below on page 4) is paid with the California From 568 annually. Estimated payments of the gross receipts fee are not required.

      S Corps: An S corporation no longer must pay an $800 minimum franchise tax on formation or during its first year of existence, but must pay an $800 minimum franchise tax on the 15 th day of the fourth month of its second year of existence. An S corporation must make additional estimated tax payments periodically throughtout each year if the 1.5% corporate level tax ( see discussion below on page 5) will exceed $800.

Types of Business.

      LLCs: A California LLC may engage in any lawful business. However, an LLC may not engage in a business which is registered, licensed or certified under the Chiropractic Code or the Business and Professions Code. As a result, professional LLCs are strictly prohibited in California.

      S Corps: S Corporations can engage in any business including professional services.

Eligible Owners.

      LLCs: There are no limitations on the types of owners. A membership interest may be held by an individual, estate, trust, C corporation, parthership, S corporation, or other LLCs.

      S Corps: Code section 1362(a)(1) limits the type and number of eligible shareholders an S corporation may have. S corporations are permitted to have 100 shareholders and the shareholders can only be individuals, estates and certain types of trusts. An individual must be a U.S. resident or citizen. Corporations, LLC and partnerships cannot be shareholders of an S corporation.

Interest for Services.

      LLCs: An LLC can issue a profits interest, distinguished from a capital interest, to a person who contributes services on behalf of the LLC and the receipt of the profits interest will generally not be a taxable event for the recipient. However, the IRS has issued proposed regulations which may cause the issuance of a profits interest to be a taxable event to the recipient unless the LLC and all of its members elect to value the profits interest on the date of issuance based on its liquidation value. These proposed regulations will not become effective until they are adopted by the IRS as final regulations. Generally the issuance of a capital interest would result in adverse tax consequences to the recipient member and potential income tax or gift tax to the transferring members.

      S Corps: The receipt of stock in an S corporation for services will be taxed at fair market value unless the stock is burdened with transfer restrictions or a risk of forfeiture. In such case, the value of the stock when the transfer restrictions or risk of forfeiture lapse will be taxable to the recipient at ordinary rates. An S corporation does not have the flexibility to grant a service provider an interest solely in profits.

Nontaxable Contribution of Property.

      LLCs: Generally, property can be contributed at any time by members of the LLC without immediate income tax consequences and without regard to the membership percentage owned by the contributor.

      S Corps: For an S corporation, in order to avoid a taxable gain on the contribution of appreciated property, the transferor shareholder along with all the other shareholders making a contemporaneous property contribution must “control” the corpotation immediately after the transfer. “Control” is defined as owning at least 80% of all stock entitled to vote and least 80% of the total number of all other classes of stock of the corporation.

Contribution of Encumbered Property.

      LLCs: When a member contributes encumbered property to an LLC or the LLC assumes the member’s liability in connection with the contribution of property, the contributing member is deemed to receive a cash distribution equal to the amount of the liability assumed and the contributing member is deemed to make a cash contribution equal to his share of the increased liability. If the net liability decrease exceeds the basis in the contributing member’s membership interest, the contributing member recognizes the excess amount as gain; however, this would generally be a rare occurrence.

      S Corps: Typically, a contribution of encumbered property does not result in taxable gain to the contributing shareholder, unless the liability exceeds the shareholder’s basis in the property, in which case a gain is recognized under Code Section 357 (c). The other shareholders are not affected by this transaction.

Operational Issues

Use of Date and Equity.

      LLCs: Each member of an LLC is entitled to include his or her share of LLC liabilities in his tax basis, which can be used to absorb flow through losses from LLC to the extent of the member’s basis. If the member is the lender generally the entire amount of the debt is allocated to such member. The members also get tax basis in their membership interest for cash contributed and the adjusted basis of property contributed to the LLC. Losses in excess of basis are suspended and not deductible by the member until basis is restored through LLC profits, capital contributions, additional allocations of LLC liabilities or member loans to the LLC.

      S Corps: Although S corporation shareholders are entieled to a tax basis in their shares for money and the adjusted basis of property contributed, entity level liabilities of the S corporation are not included in tax basis and do not give rise to a deduction for the flowthrough of losses. If a shareholder’s tax basis is reduced to zero, further losses are suspended and not deductible by the shareholder until basis is restored through S corporation profits, capital contributins or Shareholder loans to the corporation.

Types of Membership Interests or Type of Ownership Interests.

      LLCs: LLCs May issue any type of membership or ownership interest. LLCs may issue capital interests, profits interests and preferred interests.

      S Corps: The most serious disadvantage faced by S corporations is the rule precluding an S corporation from having no more than one class of stock. Thus, an S corporation may not provide a Liquidation or distribution preference to any shareholder. Even buy-sell agreements and similar arrangements must be sanitized to avoid a prohibited second class of stock.

Tax Rate Comparison.

      LLCs: The net income of an LLC is passed through to its members and taxed at their marginal individual federal and California tax rates, which can be as high as 35% (faderal) and 9.3% ( California, which increases to 10.3% on taxpayer’s taxable income over $1,000,000). In addition without proper planning , the individual member’s net earnings from self-employment (i.e., earnings from active involvement in a business as opposed to passive owner ship) are also taxed at a rate of 15.3% on the first $97,500 of income and 2.9% on all income in excess of $97,500 (in 2007) unless the individual is treated as a limited partner for these purposes under IRS regulations.

      S Corps: The net income of an S corporation is also subject to tax at each shareholder’s marginal individual federal and California tax rates. However, S corporations enjoy an advantage in the employment tax area. The combination of FICA and Hospital Insurance taxes (employer and employee’s shares combined) for an employee, including S corporation employee/shareholders is 15.3% on the first $ 97,500 (in 2007) of wages and the hospital insurance tax of 2.9% applies to compensation in excess of the dollar ceiling. By setting a reasonable salary, in this context; i.e., one that is not unreasonably too low, an S corporation shareholder can avoid these employment taxes on his share of the corporation’s income after salaries.

Certainty of Tax Status.

      LLCs: Under the IRS check-the-box regulations, an LLC formed under domestic law will automatically be taxed as a partnership if it has two or more owners. A single owner LLC is treated as a “disregarded” entity and does not have the obligation to file a separate tax return.

      S Corps: Generally an S corporation must file an election (From 2553) within the first 2 ½ months of its taxable year to be treated as a S corporation for its entire taxable year. Late elections are generally only effective on the following taxable year. Every shareholder must sign the From 2553, even the spouse is lost, the corporation cannot reelect S status for five years unless the termination was inadvertent or the IRS permits an early reelection. For most reelections, substantial detriment is incurred in the form of the built-in gains tax under Section 1374 for ten years after reelection.

      Total income in not attributable to upper-tier LLCs for purposes of the gross receipts fee. The LLC’s taxable year will close on the transfer of 50% or more of the member’s interests in the LLC within a one-year period. The final result may not be determined for some time as the Franchise Tax Board has appealed the decisions.

      Recent California superior court cases have ruled that the gross receipts fee statute is unconstitutional because it taxes all gross receipts of an LLC that does business both within and ourside of California without any apportionment. It is unclear whether the decision invalidates the application of the gross receipts fee to LLCs that only do business in California or if it only applies to LLCs that do business both within and ourside of California. The final result may not be determined for some time as the Franchise Tax Board has appealed the decisions.

      S Corps: Like LLC’s S corporations are generally not subject to federal income tax the corporate level. However, S corporations are subject to a 1.5% California franchise tax at the corporate level on the net income of the S corporation.

Use of Cash Method of Accounting.

      LLCs: There has been some concern that the IRS may have authority to prohibit an LLC from using the cash method of accounting. The IRS has, however, issued several favorable rulings permitting LLCs to use the cash method if (1) the LLC did not expect to generate losses, (2) the LLC members practice in a profession in which the LLC is engaged, (3) the LLC was not formed for tax avoidance purpose, (4) the LLC interests were not syndicated and (5) the equity partners managed the LLC. The following types of LLCs must use the accrual method of accounting: (a) LLCs that have a member that is a C corporation, (b) LLCs that use inventories and (c) LLCs that are tax shelters.

      S Corps: An S corporation may adopt the cash method of accounting unless it is a “tax shelter” under Code Section 461 (i)(3). If inventories are used, the accrual method of accounting must be adopted unless the IRS permits otherwise.

Passive Loss Limitationsl.

      LLCs: The application of the passive activity rules to LLC is uncertain. Code Section 469(h)(2) precludes a limited partner of a partnership or non-managing member of an LLC from satisfying the material participation test except where the regulations lift this restriction. A limited partner of a partnership or non-managing member of an LLC is active if he or she satishfies either (1) applicable to service activities.

      S Corps: The passive activity rules also apply to S corporations; however, each shareholder is allowed to determine to what extent he or she materially or significantly participates in each Code Section 469 activity.

Distributions in Redemption of Stock or an LLC Interest.

      LLCs: Unless the LLC makes a disproportionate distribution of Code Section 751 property (unrealized receiveables, property with depreciation recapture and appreciated property,) it recognizes no gain or loss on the distribution to its members. Generally, no gain or loos is recognized by the distribute member unless a distribution of money or marketable securities exceeds such member’s basis in the interest.

      S Corps: Distributions received by a shareholder from an S corporation that has never been a C corporation are not taxable to the extent of the shareholder’s stock basis which is first adjusted for current year’s income. A distribution in excess of basis is treated as gain on the sale of the stock. If the corporation distributes appreciated property, it recognizes gain as if it had sold the property to the distribute at fair market value and the gain is passed through to the shareholders as part of the corporation’s taxable income for the year

Capital or Ordinary Loss Treatment From the Sale of an Interest.

      LLCs: With certain exceptions, a member who disposes of his entire membership interest recognizes capital gain or loss rather than ordinary income. In certain circumstances, an abandoned or worthless membership interest may lead to an ordinary loss deduction absent a sale or exchang.

      S Corps: S corporation shareholders who dispose of their stock are treated as having disposed of a capital asset, leading to capital gain or capital loss. Code Section 1244 can benefit S corporation shareholders who sustain losses on their stock investment. If Code Section 1244 applies, Up to $100,000 loss on a joint return in any taxable year may be treated as an ordinary loss instead of a capital loss.

Special Allocations of Income or Loss.

      LLCs: An LLC operating agreement can provide for special allocations that gives a member a share of a particular item or class of items that is different from the proportion in which the member shares other profits and losses of the LLC. As long as special allocations meet the “substantial economic effect” test, the allocation will be respected by the IRS.

      S Corps: S corporations may only provide for an allocation of profits and losses to shareholders based on their pro rata share of stock ownership. Subchapter S does not permit special allocations of certain items to the shareholders. The only means by which an S corporation can “ Specially allocate” profits is by the payment of taxable compensation to the intended recipients.

Adjustment to Basis of Entities Assets on Sale or Exchange or Distribution of Property.

      LLCs: A special election is available pursuant to which a sale of an interest in an LLC or distribution of LLC property (and incertain circumstances distributions of cash) permits a basis adjustment in the property held by the LLC. LLC property is allowed a basis step-up when (1) the transferor member recognizes gain on the sale of his membership interest, (2) the distribute member recognizes gain on a distribution of cash to him by the LLC, or (3) there is a reduction in the basis of property distributed by an LLC in the hands of the distribute member. This is ususlly a beneficial adjustment that will reduce future taxable gain and increase future deductions to the members. However, (A) a sale of an interest in an LLC where the transferor member recognizes loss in excess of $250,000 on the sale, or (B) a distribution where the distribute member recognizes loss in excess of $250,000 on the distribute or (C) an increase in the basis of property distributed by an LLC in the hands of the distribute member will result in a mandatory basis step-down of LLC property. This is a detrimental adjustment that will increase future taxable gain and reduce future deductions to the members.

      S Corps: S corporations are not permitted the above basis adjustment that is available to LLCs. If the shareholder sells his stock, any gain the recognizes will provide no benefit to the purchaser, the remaining shareholders or the S corporation.

Tax-Free Reorganizations.

      LLCs: Generally, an LLC cannot be a party to a tax-free reorganization (i.e., merger) with a corporation. In certain circumstances, an LLC canengage in a tax-free merger with a partnership or another LLC.

      S Corps: S corporations may engage in tax-free mergers with other corporations pursuant to Code Section 368. Generally, S corporation shareholders recognize no gain or loss on stock exchanges pursuant to the plan of reorganization if it qualifies under Section 368. The reorganization also does not trigger a gain or loss to the S corporation.

Fringe Benefitsl.

      LLCs: An LLC may not deduct certain expenses incurred in providing fringe benefits to its members. However, an LLC may deduct accident and health insurance premiums it pays on behalf of its members to the extent paid for services and determined without regard to LLC income. 100% of health insurance premiums may be deducted by the members in 2007 on the members’ tax returns.

      S Corps: Generally the same restrictions apply to S corporation shareholders holding more than 2% of the stock of the S corporation. Accident and health insurance provided to the more than 2% shareholder/employees should be treated as compensation to the shareholder and reported as wages on Form W-2. The 2% shareholder/employees will be entitled to deduct 100% of such amounts on their personal returnes in 2007.

Incentive Compensation Plans.

      LLCs: LLCs may adopt any number of a form or variety of equity compensation plans. However, option plans for LLC interests may result in income to the recipient member as well as the other LLC members. To the extent that a member can acquire a capital interest in an LLC at a discount, a capital shift will resut in potential tax consequences to both the LLC and the acquiring member. Options for profits interst generally avoid many of these problems. The treatment of an employee who acquires an interest in an LLC is unclear. LLCs cannot issue “incentive stock options” as defined in Section 422 of the Code.

      S Corps: S corporations may adopt both incentive stock plans and nonqualified stock option plans. In addition, many S corporations maintain phantom stock plans and stock appreciation rights plans. The existing rules pertaining to equity compensation plans provide a high level of certainty to both the S corporation and the employee that is not currently available with an LLC.

Corporate Formalities.

      LLCs: An LLC is not required to have an annual meeting of the members unless this requirement is set forth in the operating agreement. Failure to hold meetings cannot be considered in piercing the LLC veil unless the operating agreement requirements that meetings be held.

      S Corps: All corporations (except statutory close corporations) must have annual shareholder and board of directors meetings. Failure to hold such meetings can be used in piercing the Corporate veil.

Asset Protection.

      LLCs: A creditor of a member may obtain a charging order and foreclose on the interest of the member in the LLC. Corp. Code Section 17302.

      S Corps: All creditor remedies are available.

orations) must have annual shareholder and board of directors meetings. Failure to hold such meetings can be used in piercing the Corporate veil.

Dissolution.

      LLCs: Generally a dissolution of an LLC does not trigger tax consequences to the members unless a member receives cash or cash equivalent in excess of that member’s basis in his or her interest in the LLC. A gain or loss triggered on the sale of assets in liquidation is generally reflected in the member’s basis in his membership interest.

      S Corps: A distribution of appreciated property to the shareholders in liquidation will trigger a federal and California income tax liability to the shareholders and the l.5% California tax at the corporate level. For this reason, S corporations are generally not appropriate for holding real estate. Gain or loss on liquidation will be reflected in the shareholders’ basis in their shares and the shareholder will recognize a gain or loss to the extent that receive cash or property in excess of that stock basis.

IRS Circuler 230 Disclosure: To ensure compliance with requirements imposed by the IRS, please be advised that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used or relied upon, and cannot be used or relied upon, for the purpose (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.