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The Tax Prophet Newsletter   Issue # 41 - Special Edition, October, 2006

REDUCE TAXES!
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In This Issue:
Introduction
Historical Differences
S Corps
LLCs
S Corp Advantages
Conclusion


Comparing S Corporations
with Limited Liability Companies


Introduction

For many small businesses, an S corporation ("S corp") or limited liability company ("LLC") are the entities of choice. Both are referred to as "flow-through" entities since the owners, and not the entity, are taxed on the income and both provide limited liability protection to the owners.

A C corporation is a separate taxpaying entity, which means it files a tax return and any earnings or profits distributed to its shareholders as dividends are subject to a second tax at the shareholder level.

Under federal tax law, C corporations pay taxes at regular corporate rates on long-term capital gains; in contrast, these gains are passed through to the S corporation or LLC owners and generally taxed at the individual long-term capital gains rate of 15%.

Historical Differences

Basically, the differences stem from historical developments: An S corp is an exception to the regular corporate tax law, so there is a constant dynamic of whether the entity meets the special S corporation rules or defaults to a C corporation.

Because it exists as a special carve-out, the rules regarding S corporations are inflexible, technical and carry a major penalty for failure - reversion to a C corporation, which means potential double taxation and no long-term capital gains tax breaks.

An LLC's genesis is the partnership concept, coupled with limited liability protection: it is extremely flexible, has little or no technical requirements and there is no concept of "defaulting" to another type of entity.


S corps

S corps have shareholders and income and losses are passed through to the shareholders, who then report their pro rata income or losses on their individual tax returns. Typically, S corps do not pay federal income tax as a separate entity.

Disadvantages include strict adherence to corporate formalities. These include holding annual shareholder and director meetings, and corporate record keeping.

In addition, S corporations: are limited to one class of stock; have limitations on the number of owners; cannot be owned by partnerships, corporations, most trusts or foreign taxpayers; have certain passive investment income restrictions; and are required to make pro-rata distributions of income, losses and profits based on the percentage ownership of the shareholders.

Also, assets owned by an S corporation cannot be stepped up to fair market value upon the death of a shareholder (the S corporation stock receives the basis step-up) which means a later sale of appreciated assets held by the S corporation may cause capital gains taxes.

In contrast, a purchaser of an LLC interest or a beneficiary of an LLC interest transferred at death may be able to increase his or her basis in the LLC's assets under partnership tax rules.


LLCs

An LLC limits the liability of its members, however it is free of the many corporate formalities that govern corporations. There are no restrictions on the number and type of members on an LLC. LLCs are "pass through" tax entities, which means that the company's losses and profits are passed through the company and taxed on the members' individual tax returns.

LLCs may hire a management group to run the LLC, which may consist of members and/or nonmembers. Members may split profits and losses as they want (called special allocations), subject to the general restrictions applicable to partnership allocations and distributions. Unlike S corporations, LLCs are not limited to pro-rata distributions based on percentage ownership.

Unfortunately, some states, including California, prevent licensed professionals from forming LLCs, unless there is a specific statutory exception in place.


S Corp Advantages

In the vast majority of situations, an LLC is the preferable entity structure for a small business because of its flexibility and lack of technical requirements.

However, there are instances when an S corporation is preferable. For example, California taxes S corporations at a rate of 1.5% on net profits, but LLCs pay taxes based on gross receipts. Thus, an entity with large gross receipts and low net profits, such as a grocery store, may pay a lower tax to California as an S corporation.

An S corporation's stock can participate in a tax-free merger or reorganization with another corporation. In some instances, an S corporation may minimize self-employment and FICA taxes, provided reasonable salaries are paid to the owners.


Conclusion

In general, unless there are state law restrictions or tax reasons for forming an S corporation, an LLC should be the preferred limited liability entity for most small businesses.



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All contents copyright 1995-2006 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.