What is the Difference Between an S Corporation and a Limited Liability Company (LLC)? Part 2
In June’s Tax News, we discussed the differences in the formation of an LLC (state law) versus an S corporation (federal election) and provided a chart showing some of the different forms these two business entities would file. In this article, we will discuss the effects on taxation. LLCs and S corporations can both provide for pass-through treatment. However, there are several significant state and federal tax differences.
Under the Corporations Code, LLCs are neither partnerships nor corporations, but they generally provide limited liability to their owners for obligations of the business. An LLC with one owner (single member LLC or SMLLC), by default, is disregarded (i.e., treated as not separate from its owner) for federal and California income tax purposes. Thus, if the single member is an individual, the disregarded SMLLC is treated as a sole proprietorship. If the single member is a corporation, the disregarded SMLLC is treated as a division or branch of the corporation. The SMLLC is required to file a return and is subject to California’s annual tax and fee. In addition, California limits the amount of any credit or credit carry forward attributable to a disregarded business entity to the amount of tax being reported by its owner attributable to the entity.
LLCs with two or more owners under the federal default rules are treated as partnerships, unless an election is made to be treated as a corporation. So an LLC with two or more members is generally treated as a pass-through entity. For federal income tax purposes the LLC is not subject to tax at the entity level, however, an LLC classified as a partnership for California purposes is required to file a tax return and is subject to California’s annual tax and fee. Since an LLC with two or more members is treated as a partnership, it must follow the federal partner and partnerships rules, Subchapter K (IRC Sections 701-777). This gives the LLC a significant amount of flexibility to vary their respective shares of partnership income. Unlike corporations, partnerships may allocate items of income, gain, loss, deduction, and credit among the members/partners, provided the allocations have substantial economic effect. In general, an allocation is permitted to the extent the member/partner to which the allocation is made receives the economic benefit or bears the economic burden of such allocation, and the allocation substantially affects the dollar amounts to be received by the member/partners from the partnership independent of tax consequences.
An S corporation also provides the federal income tax advantage of pass-through treatment. And an S corporation and its shareholders are generally treated more like a partnership and its partners than like a C corporation and its shareholders. But an S corporation can only have one class of stock and does not offer the same flexibility as a partnership to allocate income and losses among investors. California law provides for modified conformity to federal provisions relating to the tax treatment of S corporations and their shareholders. A business entity treated as an S corporation for federal income tax purposes, must file as an S corporation for California purposes. California does not conform to the federal provision (IRC Section 1363) relating to the taxability of an S corporation. S corporations continue to be subject to taxes imposed under California’s income/franchise tax provisions with specific modifications at a reduced rate (1.5 percent or 3.5 percent if it is a Financial S corporation).
Both partnerships and S corporations that conduct business both within and outside of California are required to determine California sourced income using apportionment rules. However, unlike a partnership that may be required to report on a unitary basis (pursuant to R&TC Regulation 17951-4), an S corporation is not allowed to be included in a combined report. California like federal does however allow for qualified subchapter S subsidiaries (Qsubs).
The following chart was adapted from Table 24.–Principal Differences in Taxation of Partnerships and S Corporations which was included in the May 6, 2013 report to the House Committee on Ways and Means regarding the present state of the law and suggestions for reform submitted to the tax reform working groups to assist you with principal differences.
Principal Differences in Taxation of Partnerships and S Corporations
|Item||Partnerships||S Corporations||C Corporations|
|Maximum number of equity interests.||No maximum number.
For federal tax purposes partnerships with over 100 partners may elect a special pass-through regime. Not applicable for California
|Maximum number of shareholders is 100. Family members treated as one shareholder for this purpose.||No maximum number.|
|Classes of equity interests.||No limitation.||One class of stock. Voting rights are disregarded in making this determination.||No limitation.|
|Ineligible entities.||Generally, partnerships with equity interests that are publicly traded.||Foreign corporations; financial institutions using reserve method of accounting; insurance companies; DISCs and former DISCs.||None.|
|Eligible shareholders.||All persons eligible.||Eligible shareholders include individuals, estates and certain trusts, charities, and qualified retirement plans.||All persons eligible.|
|Foreign taxpayers.||Eligible to be a partner; certain income subject to withholding tax.||Ineligible to be a shareholder.||Eligible to be a shareholder; certain income subject to federal / state withholding tax|
|Tax-exempt taxpayers.||Eligible to be a partner; income subject to generally applicable unrelated business income tax.||Tax-exempt taxpayers (other than charities and qualified retirement plans) ineligible to be a shareholder. All items of income and loss of charities and qualified retirement plans (other than ESOPs) included in unrelated business taxable income; items of income and loss of ESOPs not included in unrelated business taxable income.||Eligible to be a shareholder; dividend generally not subject to unrelated business income tax.|
|Trusts.||Eligible to be a partner; usual trust taxation rules apply.||Only qualified subchapter S trusts and electing small business trusts eligible as shareholders; special taxation rules apply.||Eligible to be a shareholder; usual trust taxation rules apply.|
|Allocation of income and losses.||Allocation in accordance with partnership agreement so long as allocation has substantial economic effect.
Nonresident partners may be subject to CA withholding tax.
|Pro rata among shares on a daily basis.
Nonresident shareholders may be subject to CA withholding tax.
|Limitation on losses.||Losses limited to basis in partnership interest, which includes partner’s share of partnership debt.||Losses limited to basis in stock and indebtedness of corporation to shareholder; no inclusion of corporate debt in shareholder basis.||Losses deductible against corporate income.|
|Contributions of property to entity.||Tax-free; built-in gain or loss allocated to contributing partner.||Tax-free (if control requirement met); no special rules allocating built-in gain or loss to contributor.||Tax-free if transferors are in control of the company after the exchange; possible exception where contributed property is subject to debt.|
|Distributions of property (liquidating or otherwise).||Generally tax-free; carryover or substituted basis to partner; partnership may elect to make basis adjustment in partnership property to reflect adjustments to distributee partner.||Gain taxed to corporation; fair market value basis to shareholder; no basis adjustments to corporate property.||Any gain in distributed property taxable to the corporation; shareholder taxed if amount of distribution exceeds stock basis.|
|Transfer of equity interests.||Gain treated as ordinary income to extent of ordinary income on assets held by partnership; partnership may elect to adjust basis of its assets with respect to transferee partner to reflect purchase price.||No ordinary income look-through provision; no adjustments to basis of corporate property.||Gain treated as capital.|
|Termination of entity.||Termination if sale or exchange of 50 percent or more of partnership interests within 12 months.||No provision.||Generally taxable to both corporation and shareholders.|
|Treatment of C corporation converting to partnership or S corporation.||Corporation must liquidate and gain or loss is recognized to corporation and shareholders.||Generally no taxation upon election; corporate tax is imposed on built-in gain if assets sold during recognition period; distribution of subchapter C earnings and profits taxable as a dividend; special rules applicable to a corporation with accumulated earnings and excess net passive investment income.||Not applicable.|
|Mergers and other reorganizations with corporations.||Not eligible to engage in tax-free reorganization with corporation.||Eligible party to a tax-free corporate reorganization.||Generally tax-free.|
|Corporate tax rules of subchapter C.||Rules inapplicable.||Rules generally applicable.||Rules applicable.|
|Wholly owned corporation.||Corporation treated as separate entity.||Wholly owned subsidiary corporation (QSub) may elect to be treated as part of parent S corporation.||Not subject to tax on dividends or liquidating distributions paid between wholly-owned subsidiaries.
For federal tax purposes, may elect to file consolidate return. For California tax purposes, combined report may be required.
|Compensation/Wages.||Except in the case of a limited partner, each partner’s share of net business income is net earnings from self-employment.||Amounts paid as compensation to a shareholder-employee are wages; no amounts are net earnings from self-employment.||Amounts paid as compensation are wages; no amounts are net earnings from self-employment.|
The check-the-box regulation allows tax classification as either a partnership or a corporation to be explicitly elective. In addition, the check-the-box regulation explicitly provides that a single-member unincorporated entity may be treated as a corporation or may be disregarded (treated as not separate from its owners). A disregarded entity is treated in the same manner as a sole proprietorship, in the case of an entity owned by individuals, and in the same manner as a branch or division, in the case of an entity owned by a corporation. An incorporated entity is always classified as a corporation. Most other business entities are considered ‘eligible entities’ that have default classification based on the number of owners (one owner- disregard/more than one owner – partnership) and can elect to be classified as an association taxable as a corporation or S corporation.
See R&TC Section 23038(b)(2)(B)(iii).
See R&TC Sections 17039(g) and 23036(i).
Treas. Reg. Sections 301.7701-3(b)(1)(i).
There are two principal exceptions to the general pass-through treatment of S corporations. Both are applicable only if the S corporation was previously a C corporation.
See also R&TC Reg 25137-1.
See R&TC Section 23801(c).
Treas. Reg. Sections 301.7701-3(a) and (b)(1)(i).
Treas. Reg. Sections 301.7701-3(a) and (b)(1)(ii).