Limited liability companies (or "LLCs") have become a very popular form of business entity because they combine the limited liability aspect of a corporation with the pass-through tax treatment of a partnership. Unlike a partnership, an LLC does not require that an owner (called a "member") take the risk of being held personally liable for the entity's actions. At the same time, an LLC receives "pass through" tax treatment, meaning that its members claim the LLC's income as their own. This avoids a double taxation situation, where the business pays taxes, but the members must also claim income from the entity on their personal tax returns.
In this way, LLC's are similar to a corporation that has filed a "subchapter S" election, referring to Internal Revenue Code Subchapter S (IRC §§1361-1379). Corporations for which a valid election under Subchapter S is in effect for a particular taxable year are referred to as "S corps," and corporations that are not S corporations are referred to as "C corps." IRC §1361(a).
While an S Corp. also permits pass-through tax treatment and shields owners (called "shareholders") from liability, an LLC has a number of advantages over an S Corp. An S Corp. can only have one class of stock, but an LLC's Operating Agreement may allocate income, gain, and loss disproportionately amongst members. Unlike an LLC, S Corp. shareholders cannot include certain categories of persons or types of entities, for example, non-resident aliens, partnerships, LLC's, or corporations. An S Corp. is also generally required to pay a reasonable salary to the owner, but an LLC is not.
Another important distinction between these two entities is the way the State of California taxes each entity. Both entities are required to pay a $800.00 minimum annual franchise tax. An S Corp. is then also taxed an amount equal to 1.5 percent of its net income. An LLC, on the other hand, must pay an additional fee if its gross revenue is at least $250,000. This additional fee, which can be substantial, depends on how much gross revenue the LLC receives.
Although there are some situations in which an S Corp. is more favorable than an LLC, the LLC has surpassed the S Corp. as the most popular form of closely held business, prompting many shareholders of S Corps. to inquire about converting to an LLC. There are some situations in which converting is desirable, but the shareholders of an S Corp. may be better off choosing not to convert to an LLC, despite its advantages. Conversion involves attorney's fees, accounting fees, filing fees, and other costs. In additions, the IRS typically treats the conversion or merger of an existing S Corp. into an LLC as a liquidation of the S Corp. that can produce negative tax consequences. If you are a shareholder interested in converting your S Corp. to an LLC, you should first consult with a CPA and an attorney about the potential tax consequences of such a conversion.
If you have questions about forming an S Corps., LLC, or other type of business entity, please contact our office for a personal consultation with an attorney.
• Forming and Operating California Limited Liability Companies (3d ed Cal. Cont. Ed. Bar).
• Organizing Corporations in California (3d ed Cal. Cont. Ed. Bar).
• Selecting and Forming Business Entities (2d ed Cal. Cont. Ed. Bar).
• Internal Revenue Code §§1361-1379.
• Revenue & Tax Code §§ 17941-17942, 23802, 23153.
• Daniel C. Schwartz, Tax Consequences of Business Entity Choice, Los Angeles Lawyer (Oct. 2014) p. 8.
About the Author: Daniel Evans is an associate attorney at Ruddell, Cochran, Stanton, Smith & Bixler. His areas of practice include buisness Law, estate planning, trust administration and probate, and real estate law.