Tax Advantages of LLCs

You desire limited liability protection for your business and, also, the single level of taxation afforded to LLCs and S corporations. From a tax standpoint, which is best? If you are the sole owner of the business, one advantage of a single member LLC is the option to disregard it for tax purposes allowing you to report the income and expenses from your LLC on Schedule C of your individual income tax return (IRS form 1040). It's one less tax return to file and, perhaps, lowers the reporting complexity enough to allow you to do your own tax return as opposed to taking it to an accountant. All 50 states allow single member LLCs. How about LLC versus S Corporation? There are subtle yet significant tax differences between LLC and S corporations.

Additional Basis For Entity Loans
If your LLC is to be highly leveraged (i.e., the LLC will borrow substantial sums) and you anticipate losses in the early years of the business, an LLC possesses one additional advantage over an S corporation. Members of an LLC allocate to their basis a portion of all LLC debt pursuant to IRC Section 752. FN1. Not so for S corporation shareholders. Even if an S corporation shareholder guarantees the corporation debt, the shareholder does not gain basis from the debt. Pursuant to IRC Section 1366, S Corporation shareholders obtain basis only for contributions of capital. This means an S corporation shareholder, to obtain a basis increase for debt, must take out the loan him or herself as the primary debtor then contribute the loan proceeds to the corporation. Link. Why is this important? LLC and S corporation owners are limited in the deduction of entity losses to the amount of basis. Thus, members of a leveraged LLC are allowed to deduct greater losses than similarly leveraged S corporation shareholders.

Contribution of Appreciated Property
LLC members, whether majority or minority members, can contribute substantially appreciated property to the LLC without tax consequences. Even tax free distributions of appreciated property from LLCs is allowed under IRC Section 731. Not so with S corporations. Only where the shareholder is in control of the S corporation immediately before and after the transaction is a contribution of appreciated property by an S corporation shareholder a non-recognition event (i.e., tax free). See IRC Section 351. When contributing assets other than cash to an LLC, it is important for the operating agreement to list the assets to be contributed by each member and, also, the agreed value of each asset. See LLC Operating Agreement examples linked here.

Pluses for C corporations
Corporations can offer a greater range of deductible fringe benefits to employees as opposed to LLCs. Please speak with your tax accountants about the specifics. Also, a corporation which has significant assets or non-owner employees may be able to pay out a certain percentage of its profits in dividends as opposed to straight compensation. That could save you the 15+% FICA tax on wages. It can add up to a significant savings for a small business. The IRS is sensitive to inappropriate small owner-officer salaries to circumvent this problem so be prepared to justify any salary chosen.

See also Why Real Estate Businesses Chose the LLC Form


Footnote 1: "Any increase in a partner’s share of liabilities of the partnership is considered a contribution by such partner to the partnership, and, consequently, increases the basis of the partner’s interest in the partnership. Sec. 752(a); sec. 1.752-1(b), Income Tax Regs.; see HGA Cinema Trust v. Commissioner, 950 F.2d 1357, 1362 (7th Cir. 1991), affg. T.C. Memo. 1989-370; Callahan v. Commissioner, 98 T.C. 276, 280 (1992)." IPO II v. Commissioner, 122 T.C. No. 17 (2004), Slip Op. at page 9. Partnership liabilities are allocated in two different methods depending on whether the partnership debt is recourse or nonrecourse. For recourse liabilities, partners are allocated partnership debt based on their economic risk of loss (EROL). EROL is determined by determing a partner’s liability for the debt in question upon constructive partnership liquidation. "Section 1.752-3(a)(2) provides that the partner's share of the nonrecourse liabilities of the partnership includes the amount of any taxable gain that would be allocated to the partner under section 704(c) (or in the same manner as section 704(c) in connection with a revaluation of partnership property) if the partnership disposed of (in a taxable transaction) all partnership property subject to one or more nonrecourse liabilities of the partnership in full satisfaction of liabilities and for no other consideration. The gain a partner would be allocated under the hypothetical sale in section 1.752- 3(a)(2) is referred to as section 704(c) minimum gain." LTR 200120020. See more detailed discussion of issue; See also at-risk rules of IRC § 465. IRC Section 752 applies equally to partnerships and LLCs in cases where the LLC is taxed as a partnership.

Personal Liability of LLC Members

LLC stands for "limited liability company". I am often asked by those forming LLCs, how much protection do I get from an LLC for my personal assets? Section 303 of the Uniform Limited Liability Company Act (upon which all state LLC acts are based) reads, in pertinent part, as follows:

(a) [T]he debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.
* * *
(c) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:
     (1) a provision to that effect is contained in the articles of organization; and
     (2) a member so liable has consented in writing to the adoption of the provision or to be bound by the provision.

Bottom line: an LLC member has no personal liability for LLC debts unless "a member so liable has consented in writing to the adoption of the provision or to be bound by the provision."

But here's the rub: an entrepreneur starting a new business is universally required to guaranty everything to get credit for the new LLC--suppliers, utilities, commercial real estate lease, bank loan, etc. What about the credit card offer that is sure to come in the mail a few months after you open an LLC bank account? On its face, the credit card offer appears in the name of the business but you the owner invariably guaranty the account (check the fine print on the back of the offer). So if the owners of a new LLC are required to guaranty every element of credit, is the promise of limited protection just an illusion? No, I think not. As the new LLC gains its legs over years of operation, suppliers and other will begin to offer credit terms to the LLC without guaranty based upon the LLC's own credit history. Secondly, above we have been discussing contractual liability for loans.

But businesses also face tort liability for such things as personal injury claims. Let's say your LLC runs a coffee shop and an elderly female patron falls breaking her hip. The hip surgery goes poorly causing the old woman to spend months in the hospital. The hospital bills and claimed pain and suffering in the suit brought by the patron against the coffee shop exceed its liability insurance coverage. This is the type of liability situation that the LLC form of business affords protection to business owners regardless of personal guaranty. What if you are one-person computer programming consulting operating out of your house? Where tort liability exposure is low, the incentives for the small business owner to utilize the LLC structure diminish for asset protect purposes. There may be tax reasons for forming an LLC even in a low tort business but please consult your tax account for insight on that issue.