S Corporation vs. LLC in California Here is an overview of the differences between doing business as an S corporation or as an LLC.

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1 S Corporation vs. LLC in California Here is an overview of the differences between doing business as an S corporation or as an LLC. After you have read this article, we can discuss in detail what would be best in your situation. Please be aware that under the California Business and Professions Code, professional businesses cannot form LLCs. The list of professional businesses includes physicians, engineers, accountants, attorneys, and architects. However, at present we do not have a precise definition of profession for purposes of the LLC rule, so we are not sure if realtors, contractors, cosmetologists, etc. are considered professionals. LLC is easier Forming and operating as an LLC requires less effort than a corporation. An LLC is not required to have annual meetings or minutes. An LLC with less than $250,000 in gross receipts and less than $250,000 in assets is not required to have a balance sheet. A single-member LLC includes, losses, and deductions on the member s return. The only California filing requirements are Form 568, Limited Liability Company Return of Income, to pay the annual fee based on gross from California sources, and Form FTB 3522, Limited Liability Company Tax Voucher, to pay the annual tax. Estate planning Many individuals use the LLC to transfer assets to their children. By contributing property to an LLC, the parents can make small gifts of the property to the children using the annual gift tax exclusion. When the parents die, the value of the property may be reduced for estate tax purposes because the parent does not own 100% interest. The LLC is superior to the S corporation in this area because: The beneficiaries receive a stepped-up basis in the assets of the LLC that they do not already own prior to their parents death, providing them with increased depreciation. The IRC 754 election is available to the LLC but not the S corporation. (See the explanation of the IRC 754 election that appears in the special allocations and depreciation section below). While the parent is alive the beneficiaries can be classified as nonmanaging members and have no say in the operation of the business. This is not possible in an S corporation because the S corporation does not allow for different classes of stock. The LLC may make disproportionate distributions to the parent or the beneficiaries. In an S corporation, the distributions must always be in proportion to stock ownership. Liquidation Although there is no double tax at the liquidation of the S corporation, the will recognize gain or loss on the liquidation. When an LLC liquidates and distributes assets to the members, the members do not have a taxable event unless the value of cash, inventory, and unrealized receivables is greater than the member s basis. Special allocations and depreciation An LLC, like a partnership, may make special allocations of or loss based on a member s contributions. LLC members can even keep separate sets of books, combine them at the end of the year to file the return, and share certain expenses. For example, a set designer and a costume designer form an LLC. They share an office and telephone and office expenses, but each generates their own and pays their own expenses attributed to the project. The LLC provides these individuals with a vehicle to calculate their separate profit, allocate shared expenses, and pay the net to each member as a guaranteed payment. The LLC is treated like a partnership and, as such, a new owner may take advantage of the IRC 754 election. This election allows the member to step up the outside basis on the assets acquired and depreciate them based on the FMV of the assets when the LLC interest was acquired. A new of the S corporation may have an increased basis in the stock but does not get a benefit for the depreciation increase. A corporation is more formal. The benefit to the formality is that it protects s and keeps them informed of the activities of the corporation in which they have invested. An S corporation may also have more stature in the business world. The LLC is relatively new and creditors may feel more comfortable doing business with an S corporation than with an LLC.

2 In the tax and legal arenas, we aren t always sure how an LLC will fare. There is little case law so far and uncertainties surround these areas: Can an LLC member walk away without paying the FTB fees and taxes? We know an S corporation can walk away, if certain conditions exist. How are passive activity losses treated in an LLC? Which members of an LLC are subject to self-employment tax? Tax issues An S corporation offers the ability to limit payroll taxes. If structured correctly, the / employee may take a reasonable salary subject to all employee and employer payroll taxes and be taxed on the profits as a dividend distribution. This way, not all the distributions taken from the S corporation are subject to payroll taxes. NOTE: This benefit is reduced when the exceeds the FICA threshold. After that, the LLC member pays only the 2.9% Medicare. An LLC managing member must pay self-employment tax on his or her share of the net from the LLC whether or not it was distributed. The LLC member also pays self employment tax on the amount contributed to a pension plan. The /employee s pension contribution comes directly off the of the corporate return and is not subject to payroll tax. Converting from a single-member LLC to a multi-member LLC or vice versa will create two different tax returns and accounting issues. An S corporation is not impacted when s change. Also, a 50% ownership change does not terminate an S corporation, whereas when an LLC has a 50% or more change of ownership, a final return, and a first-year return must be filed for the old and new owners. What does each cost? In California the cost of either entity is high. The S corporation itself pays the greater of 1.5% tax or $800 to California and the s also pay tax on the. The S corporation is forgiven the $800 minimum tax in its first year, although it still must pay tax on the net, even if it is less than $800. The LLC pays $800 annual tax for all years. There is no first year free rule for LLCs. LLCs must also pay the annual fee based on total. For the 2008 year, the fee ranged from $900 for an LLC with total of $250,000 to a maximum of $11,790 for total in excess of $5 million. So, which is best? There is no single answer to this question. But, first ask yourself: How much will each entity cost in tax, accounting, and administration for tax and accounting? Then decide which structure is best. It seems that for estate planning purposes, the LLC gets the nod. For a business that needs or wants more established and stricter requirements, the S corporation may better fit the bill.

3 Comparison of LLC/S corporation/c corporation Owners Unlimited number of members Unlimited Cannot register in CA as an LLC if providing professional services Limited to 100 s Cannot be foreign Only individuals and certain trusts Who pays tax? Income/loss flows to Income and loss flows to CA tax of 1.5% of net C corporation pays tax at graduated rates Federal: 15-35% (Personal service pays at 35%) California: 8.84% California taxes $800 annual tax + Annual fee $0 to $11,790 Greater of $800 minimum tax or 1.5% of net Greater of $800 or 8.84% of net Suitability to hold investments Individuals pay tax at reduced capital gains and dividend rates Possible tax on net passive investment if previously a C corporation Double tax on distributions No reduced federal capital gains Tax year Same as members unless elect IRC 444 (maximum 3 month deferral) or qualify as natural business year Same as members unless elect IRC 444 (maximum 3 month deferral) or qualify as natural business year Generally any year Basis & at risk issues Member s share of LLC liabilities plus loans guaranteed by member are part of basis Guaranteed loans do not increase basis. Shareholder s basis is stock basis plus loans made by N/A Inherited basis Beneficiary may make IRC 754 election and receive step up in assets Stock basis receives step up but S corporation assets do not receive step up Stock basis receives step up but S corporation assets do not receive step up Compensation Members are never employees. Managing and working members are subject to S/E tax on guaranteed payments and ordinary Must take reasonable compensation as wages subject to payroll taxes Must take wages subject to payroll tax Reasonable compensation issues

4 Medical insurance Comparison of LLC/S corporation/c corporation Not deductible by LLC Deductible from C above the line deduction corporation not for member included in W-2 Included in wages of >2% abovethe-line deduction (see IRS Notice ) Medical reimbursement plan Not available to member Not available to >2% Deductible by C corporation not included in W-2 Charitable contributions Flow through to member Flow through to up to 10% of taxable deductible by CA corporation Deductible by C corporation limited to 10% of taxable Capital losses Flow through to member Flow through to ; not deductible by CA S corporation Losses carried back 3 years and forward 5 years for federal and forward 5 years for CA Selling the entity Sale of membership interest is capital gain/ Ioss May be subject to IRC 751 ordinary treatment Sale of stock is capital gain/ioss May qualify for IRC 1244 loss Sale of stock is capital gain/loss May qualify for IRC 1244 loss or IRC 1045 small business gain exclusion (R&TC ) Liquidating the entity Gain flows to owner Tax on gain but not on distribution (gain increases basis) Gain flows to owner; generally no federal tax on gain (gain increases basis) CA S corporation tax at 1.5% rate Corporate tax on gain; tax on distribution in excess of basis (no increase in stock basis due to gain) Distribution of assets in complete liquidation No tax except to the member if cash exceeds basis; member pays tax when assets are sold Gain reported as though assets sold at FMV Gain flows to owner CA S corporation tax at 1.5% rate Corporate tax on gain as though assets sold at FMV Tax on distribution to in excess of basis Distributing profits May make unequal distributions Must make pro rata distributions of profits May have more than one class of stock so distributions not necessarily equal

5 Comparison of LLC/S corporation/c corporation Restrictions Non-managing members may be restricted in sale of interest; have no authority to manage Only one class of allowed so no restrictions on selling shares; all s have voting rights May have more than one class of stock; some can be nonvoting Single owner A single member LLC is a disregarded entity, meaning the and losses are reported on the member s return; the member may have additional liability exposure No difference from multiple members No difference from multiple members Passing interest to children Children, even if working in the business, can be restricted from selling their interest; there is creditor protection with an LLC Children who are s may sell their shares and have whatever minority rights are available under state law; s do not have creditor protection Children can be issued different classes of stock; s do not have creditor protection Ownership change Multiple returns One return Multiple K-1 forms One return Adding members No gain Gain if contribution of assets Wages if services in exchange for stock Gain if contribution of assets Wages if services in exchange for stock