SOME SIMILARITIES AND DIFFERENCES IN THE TAXATION OF THE OWNERS OF S-CORPORATIONS AND LIMITED LIABILITY COMPANIES
Usually, the primary reason for forming an S-corporation or an LLC is to protect the assets of the owners from liability exposure. It is also important to pay attention to the tax needs of the owners, in anticipation of the day when they may wish to sell the business, or just a certain percentage of ownership, or some of the business’ assets.
The reader is asked to bear in mind that the legal principles cited in this article are not a complete exposition of the principles of limited liability company, corporate or tax law, and so may not apply to an individual’s particular situation. This article is not intended as legal advice for anyone, and is simply intended as an illustration of certain aspects of the law.
Corporations, LLCs, limited partnerships and the other types of entities that can be created under Pennsylvania law, and in most states, all provide this essential protection from liability. S-corporations have more non-tax related limitations than do LLCs. For example, S-corporations are limited in the type and number of shareholders. Classes of stock in a sub-S must be identical except for voting rights, and distributions of profit must be in proportion to each stockholder’s percentage share of ownership.
Most small businesses are organized as S-corporations, LLCs or limited partnerships because they all permit “pass through” taxation, meaning the net income or loss drops directly to the owner or owner’s tax returns. No tax is paid at the corporate level, so the owners are only taxed once. C-corporations, of course, are subject to double taxation: corporate income tax and then tax on dividends at ordinary rates. S-corporations, LLCs, limited partnerships and the other variants of these entity types all allow the owners to elect to be taxed as a partnership, giving them the benefits of pass-through taxation.
LLCs, limited partnerships and even general partnerships (which do not protect the partners from individual liability) are automatically taxed as partnerships for federal and state income tax purposes. Corporations, on the other hand, are presumed to be C-corporations when formed, unless the corporation makes an election at the federal level to be taxed as an S-corporation. In this brief and limited discussion of pass through taxation, we will assume we are dealing with either an S-corporation or an LLC.
With both the LLC and the S-corporation, for tax purposes, income is passed through to the owners. Losses are passed through also, subject to certain restrictions such as limitations on passive investment activity. In addition, distributions of appreciated assets from an S-corporation are taxable events.
One significant limitation of an S-corporation compared to an LLC or partnership is that there is no method of equalizing the “inside” basis of an asset contributed by an owner to the entity with the “outside” basis. The “inside basis” is the tax basis of the asset on the books of the entity. The “outside basis” is the tax basis in the hands of the owner. This difference can be an issue when there is a sale of all or part of the S-corporation’s stock or a membership interest.
In such a situation, the buyer of stock or a membership interest in an LLC will have a different tax basis than that of the entity, unless the entity is taxed as a disregarded entity, or as a partnership and a Section 754 election is made. “Inside” basis can be adjusted to “outside” basis with a Section 754 election. For example, if an LLC has as its only asset real estate with a basis of $100,000 and a fair market value of $5 million, a buyer of half the membership interest for $2.5 million would have a basis of that amount in the membership interest. The LLC, on the other hand, would retain the $100,000 basis.
The buyer of the LLC membership interest can make an election under section 754 of the Code and equalize the inside and outside basis. Section 754 applies only to entities taxed as partnerships, such as LLCs, and not to C- or S-corporations. It applies only upon the transfer of an interest in a partnership by sale or exchange, or upon the death of a partner, and it applies only to the buying partner. The result is that the basis on the LLC’s books is increased to reflect the new owner’s basis.
Generally, no taxable event occurs upon formation. At formation, the owners’ basis in the entity’s stock or in the LLC membership Interest is equal to the basis of the assets contributed when they were in the hands of the LLC owners. There may be some adjustment for any gain recognized upon contribution. After contribution, the entity’s basis in the assets is the contributing owners’ basis, adjusted for any gain recognized upon contribution.
During the course of entity operations, income and gains are passed through to each member or shareholder. If there is income or gain, each owner’s basis in the stock or LLC Membership Interest is increased. If there are losses, they are passed through to the owners. Each dollar of loss reduces the basis in the stock or membership interest and is deductible to the extent permissible.
When the S-corporation or LLC distributes cash or other assets to the owners, there is a dollar-for-dollar reduction in basis in the stock of an S-corporation or LLC membership Interest. This will cause the individual shareholder or membership interest holder’s basis to fluctuate.
