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Deals & Dealmakers

LLC versus S-Corp: What business type is right for you?

By Donald Bender, Maryann Richer, Sam Pizzichillo & Garret Golden, WeizerMazars

When a client enters into a real estate transaction, one of the first questions they often ask their accountant is about entity structure.

What was once a question of partnership or S-Corporation, has now generally become a question of limited liability company (LLC) or S-Corporation.

This article will try to highlight many of the key advantages or disadvantages of an LLC vs. an S-Corporation for owner-operator real estate entities.

Most of the advantages and disadvantages discussed for LLCs also hold true for partnerships.

Before discussing the differences between LLCs and S-Corporations, it is important to understand their similarities. Both are separate legal entities, created under the laws of a state, with “pass-through” taxation treatment.

As pass-through entities, generally no federal income taxes are incurred at the entity level. Rather, business profit or loss gets reported on a Schedule K-1 and is passed through to the owner to be reported at the personal level, where income taxes will be assessed.

For single-member LLCs a separate tax return is not required by the IRS. These are considered disregarded entities for tax purposes and the LLC’s activity is reported directly on the personal tax return.

Pass-through taxation is advantageous as shareholders in a C-Corporation face potential double-taxation.

This results from the C-Corporation paying tax at the corporate level on its profits, which are again taxed at the individual level when shareholders receive dividend distributions.

Another similarity between the two entity types is that both offer limited liability protection. This means that owners are typically not personally responsible for the entity’s debts and liabilities. In other words, personal assets are protected from creditors of the business.

One feature that distinguishes the LLC from an S-Corporation is its operational ease.

There are far fewer forms required for registering an LLC and they are not required to have formal meetings or to keep minutes.

Furthermore, LLCs can have an unlimited number of members, whereas S-Corporations can have no more than 100 shareholders.

Moreover, LLCs can allocate income or loss disproportionately among the owners, based on the operating agreement.

However, in an S-Corporation, income and loss are assigned to each shareholder based on their proportionate share of ownership.  Additionally, non-U.S. Citizens can be members of LLCs but cannot be shareholders of S-Corporations.

A key advantage of an LLC over an S-Corporation for real estate investors is the inclusion of liabilities in the calculation of the owner’s basis in the entity.

Generally, S-Corporation owners obtain basis through capital contributions, amounts used to purchase the stock, loans made by the shareholder to the S-Corporation, or through the allocation of income (allocation of loss would reduce basis).

The S-Corporation owner receives no basis from liabilities or guarantees of the S-Corporation’s debt.

Similar to S-Corporations, an LLC member’s basis includes contributions to the LLC as well as their allocation of income or loss.

Additionally, liabilities of an LLC are treated as contributions of money by the members and thereby increase the members’ basis. The ability for a limited liability owner (a member) to include certain types of debt in his or her basis can allow for tax free distributions, or for the owner to deduct losses in excess of his or her cash investment, subject to the passive loss regulations of IRC 469.

Another key advantage of an LLC over an S-Corporation is that the Internal Revenue Code allows an LLC to make an election to “step-up” the basis of its assets.

Upon the death of an LLC owner or the sale of an ownership interest, the successor owner may be able to increase his or her basis in depreciable real property if the fair market value of the property exceeds the amount of his or her capital account at the time of the transfer.

This increase in basis would also allow the successor member to reduce his or her taxable gain in the event of a sale of the LLC interest or of the underlying assets held by the LLC.

However, if the capital account exceeds the fair market value of the property at the time of the transfer, the reverse of the tax consequences previously outlined could occur.

These “step-up” elections are not available for S-Corporation shareholders.

An LLC also holds an advantage over an S-Corporation in terms of favorable tax treatment upon liquidation. When liquidating its assets, an LLC (treated as a partnership for tax purposes) can distribute its property tax free.

On the other hand, liquidation of an S-Corporation is treated as a sale at fair market value and can trigger a taxable event.

One situation where an S-Corporation can be more advantageous than an LLC is in the case of Cancellation of Debt Income (‘COD”). If the S-Corporation is insolvent and has COD as defined under the Internal Revenue Code, the S-Corporation shareholder will not be taxed on the COD income.

While an LLC owner may be able to exclude the income under the insolvency exception if the owner is personally insolvent, this entity level exclusion is not available.

In consideration of the items discussed above, LLCs offers many advantages over an S-Corporation for real estate owner-operators and are generally the preferred choice.

However, it is important to understand the key differences between the two as certain circumstances may impact the selection of one entity type over the other.

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