September 2, 2016

S Corporations and LLCs Compared

At first glance, a subchapter S corporation (commonly called an “S corp”) appears to have all the same advantages as an LLC. Like an LLC, the S corporation allows pass through taxation for the owners–no double tax like that faced by the owner of C corporation. An S corp also has limited liability protection for all owners.

But this is where the similarities end.

Flexible Ownership Structure

The LLC has the most flexible ownership guidelines of nearly any business entity. Of course, individuals can own an interest in an LLC, just as individuals can own an interest in an S or C corporation. However, LLCs allow much more. LLCs can be owned by trusts, partnerships, other LLCs, C corporations, and limited partnerships. S corporation interests can only be owned by individuals. This can make S corporations unattractive for certain asset protection purposes.

The LLC has no legal limit to the number of shareholders. S corporations are limited to 75 shareholders.

Tax Advantages Through Flexible Allocation of Profits

The members of a limited liability company have a lot of flexibility in determining how they want to allocate profits. They can of course allocate profits in proportion to ownership–i.e. if member A owns 30% of the LLC, A receives 30% of the profits. But members of an LLC can get more creative, and can allocate profits and losses in any manner they choose. This can have significant tax advantages, particularly if the LLC members are in different tax brackets–i.e. one could allocate losses to high bracket owners and profits to lower bracket tax payers.

S corporations, by contrast, must allocate profits in proportion to ownership. There is none of the flexibility of the LLC that can be so useful in tax planning.

Furthermore, the S corporations’ use of paying profits in the form of dividends that were exempt from self employment taxes has been somewhat diminished by Obamacare’s 3.8% medicare tax on dividends.

Asset Protection

Another characteristic of LLCs is that an owner’s interest is not freely transferable.

In an S corporation, ownership interests are freely transferable. Free transferability means that one owner can sell their interest without getting permission or approval of other owners.

In an LLC, for an owner to sell his shares usually requires the permission of other owners (technically, owners of an LLC are called “members”).

This characteristic has advantages and disadvantages. The disadvantage for an LLC is that not having free transferability makes passive ownership of an LLC (i.e. being an outside investor not working on the day to day operation of the company) less attractive.

On the other hand, the lack of free transferability can be very useful for asset protection, and can allow members of an LLC to protect the assets within the LLC from personal creditors of the members.

This is a key attribute that other business entities, except for the limited partnership, don’t have. It’s the difference between inside-out protection and outside-in asset protection. An S or C corporation will protect an owner from being liable for business debts; this is inside-out protection (the corporation “holds” the liability within the entity and keeps it from attacking the owner’s personal assets).

What an LLC can do, if properly set up by an experienced attorney, is protect an owner’s interest in the assets of an LLC from the owner’s personal creditors. This is outside-in protection. For example, if X is an owner with a personal debt, say from a personal loan, a properly structured LLC can prevent X’s creditor from taking the assets within the LLC. If X owned stock in a C or S corporation, the creditor could simply attach the stock, take it and sell it to a third party.

With an LLC interest, the creditor can only get what’s called a “charging order” against the interest. The creditor is only entitled to distributed profits; if the other members of the LLC decide not to distribute profits, the creditor gets nothing.

Even worse for the creditor, if the LLC is earning a profit, the creditor might be liable for taxes on that profit without having been given the profits to pay the taxes. There are more complications to this scenario, and this is simply an introduction.

There’s an entire asset protection industry built around this function of LLCs, and to a greater extent, limited partnerships, which is beyond the scope of this article. But I did want you to know that it exists, in case you want to investigate it further.

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