Tax Comparison Between S Corporations and LLCs
A. FEDERAL INCOME TAX ADVANTAGES OF SUBCHAPTER K (Partnerships) COMPARED TO SUBCHAPTER S CORPORATIONS
- There are no eligibility or election requirements to meet in order to take advantage of Subchapter K for partnership tax treatment.. Corporations must meet onerous requirements to qualify for Subchapter S tax treatment.
- Subchapter K can provide for special allocations (Section 704(a)) among partners. Subchapter S requires each shareholder to be treated the same eliminating some tax planning strategies.
- Under Subchapter K, partnership basis may be included in the partners’ bases in their partnership interests. Shareholders of S corporations can only include in the basis of their stock amounts they lend to their corporation.
- Distributions of assets from Subchapter K are generally tax-free. Distributions of assets from S corporations are treated as sales of those assets and can trigger gain or loss.
- When a partnership redeems a partner, the other partners get an inside basis step-up. When an S corporation redeems a shareholder, there is no inside basis step-up at the corporate level.
- When partners sell their partnership interest to other partners or to third parties, the buyers get inside basis step-ups. When shareholders of S corporations sell their stock to other shareholders or to third partnerships, the buyers don’t get inside basis step-ups.
- Partnerships can grant partnership interests to existing and new partners in exchange for past or future services. S corporations cannot.
B. FEDERAL INCOME TAX DISADVANTAGES OF SUBCHAPTER K AS COMPARED WITH SUBCHAPTER S
- Sales of interests in partnerships can trigger ordinary income treatment for the sellers with respect to ordinary income assets. Not so for sales of Subchapter S stock.
- Partnership contractual arrangements-e.g., concerning options to purchase partnership interests and grants of restricted partnership interests-can involve complex and expensive specialized drafting and may raise issues to which there is no clear answer. S corporation grants of stock options and restricted stock don’t usually involve complex drafting or unresolved issues.
C. REASONS TO FILE AS A LLC BUT TO BE TAXED AS S CORPORATION
An LLC taxed as an S corp is same as a straight S corp. In addition to being a shareholder, the owner-officer of an S corp who performs services on behalf of the S corp is considered to be an employee of the S corp.