This is one of the most frequently asked questions we get from small business owners. Like many tax and business questions, the answer is, “It depends!”. We will explain a few of the many nuances that should influence your decision, but it generally boils down to the answers to a few questions. The answers to the following three questions are a good place to start:

1.    Are you forming the entity to invest or to operate a business?

2.    Do you have multiple owners and will you need to specially allocate income to any of the owners?

3.    How likely is it that you will ever want to distribute appreciated assets from the business to one of the owners?

Are you forming the entity to invest or to operate a business?

Unlike S corportations ("S corps"), the net income from an LLC taxed as a disregarded entity (“DRE”) or a partnership that is operating a trade or business is subject to 15.3% self-employment tax (“SE tax”). This is in addition to regular income tax and this applies whether there is one or multiple owners. If you receive significant wages or other self-employment income from other sources, this may help reduce this impact. Generally, ownership of real estate activities by an LLC are not subject to SE tax unless significant services are provided in connection with the operation of the real estate. An example of this is a hotel.

 Therefore, our normal recommendation is to use LLCs to own real estate or other investment assets and to use S corps to own operating businesses.  However, this depends on your individual circumstances and should be discussed with your attorney and CPA.

 One final point to consider is that while the earnings of an S corp are not subject to SE tax, the S corp is required to pay reasonable compensation to all shareholders for the work they provide to the S corp. This requires the S corp to pay payroll to the owners and provide them with W-2’s to report the wages. Failure to do so could result in all income from the S corp being subject to SE tax. So, while there is an opportunity for an S corp business to save SE tax if reasonable compensation is less that total net income of the business,  this savings is partially offset by the additional cost and inconvenience of preparing payroll checks and the required tax filings.

 Do you have multiple owners and will you need to specially allocate income among the owners?

S corps are generally our entity of choice to own operating businesses. However, tax attributes such as income, losses, and other separately stated items may only be allocated to the owners based on their proportionate share of the stock they own. Any special allocations to owners of an S corp would have undesirable tax consequences. If an S corp is deemed to have a second class of stock, the S election is terminated and the S corp changes from a pass-through entity, where one level of income tax is paid at the individual level, to a C corp, which must pay tax at the corporate level in addition to the tax paid at the shareholder level. Therefore, if you need to specially allocate items among owners, an LLC taxed as a partnership will likely be your choice.

There are other structuring alternatives that can allow you to have the best of both worlds, if the size of the transaction and the net income justifies the additional cost of multiple entities.

How likely is it you will ever want to distribute appreciated assets from the business to an owner?

While this is a rare occurrence, it does sometimes happen with real estate assets and when assets are being sold. LLCs taxed as partnerships can, with the proper planning and documentation, distribute assets tax-free to the owners and to other partnerships in exchange for an interest in that partnership.

 In other words, an interest in one partnership can be exchanged for an interest in another partnership tax free. These are extremely complex rules and should never be attempted without assistance from your attorney and CPA.  Generally, distribution of an appreciated asset from an S corp is treated as a deemed sale and tax must be paid on any gain recognized. Even distributing an asset from an S corp to a 100% shareholder is a deemed sale. Since this type of distribution typically only happens with real estate, this is another reason to use LLC’s to hold real estate.

 While the answers to these questions are useful in helping you decide whether your business should be an LLC or an S corp, your unique circumstances are equally as important. Let us help you start with a strong foundation by identifying the entity structure that is right for your business.