Careful When LLC Taxed as S Corp
Your startup business is organized as a LLC and you have consulted with your small business lawyer and tax adviser about whether you should elect to be taxed as a S corporation. Your startup lawyer has filed the papers to organize your LLC in Washington DC or elsewhere. You decided to make the S corp election to save self-employment taxes—a good reason for many small business owners.
All is well and good, except that there are looming traps for the unwary. When you talk with your tax adviser or your startup attorney, you want to come prepared and understand that the S corp election may pose some financial risks for you. This article describes some of the looming risks for those business owners who have elected for their LLC to be taxed as a S corp. This article is not meant to provide tax or legal advice, rather to highlight some of the issues that you as the small business owner may face and will want to make an informed decision with you small business attorney or tax adviser.
Conversion from S corporation to partnership not tax free.
There may be some reasons for organizing as a S corporation because of the self-employment taxes or because it is easier to convert an S corporation to a C Corporation. The first word of caution is that even if a S corporation is the logical choice when you form your business, it may not work for you later on down the line. If your company is organized as a S corporation or a LLC taxed as a S corporation, you may have to consider converting to a LLC taxed as a partnership. If you have a LLC taxed as a S corporation, you need to let the IRS know.
If your small business is organized as a S corporation, you can convert from a S corporation to a LLC. In some states, all you need to do is file a form. In other states, you will need to create a new LLC and merge the S corporation into it. In the District of Columbia, a S corporation may convert to a LLC by approving a “plan of conversion.” The biggest concern is the tax consequences. The conversion to a LLC taxed as a partnership will be treated as a liquidation and may trigger a gain on all of the built up appreciation. If there has been any embedded gain in the company, the conversion could be rather painful.
Investor contributions to the LLC.
Investor contributions of appreciated property
For many startup businesses that we see at Rosten Law, the partners are the investors and they contribute cash in proportion to their membership interests. The partners intend to spend roughly an equal amount of time on the new business. This common fact pattern does not pose a risk at least at the startup phase. But if you diverge a little from this general pattern, then it can get complicated. What if one of the partners contributes real property that has appreciated in price or puts into the business patents or appreciated securities. Or what if one or more of the partners incurs non-recourse debt to purchase a piece of property
For some new businesses, an investor may make a contribution of appreciated property. Whether there will be tax consequences depends on whether the new business receiving the contributions of appreciated property is a single member or multi-member LLC. If you have a single member LLC, then contributions of appreciated property when you form the LLC do not trigger federal income tax to you or to the LLC. The basis in the property for the one contributing the property is the same as immediately before the contribution.
But when you have a multi-member LLC, how you are taxed depends on whether you have elected to be taxed as a S corporation or a partnership. If the LLC is taxed as a partnership, the Internal Revenue Code has formulated special rules. The gain before the business formation is allocated to the partner who has contributed the property. If the LLC sells the property, the pre-formation gain is allocated to the individual partner who contributed the property and any gain after the formation is allocated to the LLC members according to their percentage ownership. The property is treated as if the contributor sold the property to the business at the time of formation. If you have a LLC taxed as a sub S, there are not these special rules. So if you are the LLC member contributing appreciated property to a new business, it is more advantageous for the LLC to be taxed as a S corporation, but for the remaining members, it is more advantageous for the LLC to be taxed as a partnership.
For an existing business, contributions of appreciated property to a LLC taxed as a partnership do not have tax consequences. Regardless of whether the contributor is a new or existing member of the LLC, there is no tax liability when the investor contributes appreciated property. For a sub S, there are certain restrictions regarding when the contribution is not taxable. The Internal Revenue Code requires that the contributor own stock having at least 80 percent of the combined voting power of all classes of stock for the transfer to the sub s to be considered a taxable transfer.
Contributions of services by LLC members
Many businesses want to have a structure to provide appropriate incentives to attract the best and brightest talent. The way that businesses provide these incentives through an LLC is to provide prospective employees with equity in the LLC by issuing what is known as “profits interests.” These profits interests share of the increase in value of the LLC over a specific period of time. Vesting can be attached to this interest. In a partnership, a member may receive a “profits interest” for contributions of past or future services.
A LLC taxed as a sub S may only have one class of stock and accordingly cannot grant a profits interest to members. This can be a major issue if you are trying to bring in a new member to your LLC treated as a sub S. Let’s say you want to bring in a new partner who wants to join but only if he or she gets a stake in the LLC. If you have a LLC taxed as a partnership, you can give him a profits interest—not so with a S corporation. Let’s say you have a $1 million company and you want to give him 10% interest, and boom, he or she will be hit with taxes on $100,000. Consequently, if you are considering giving a profits interest to members of your LLC in exchange for past or future services, then you may not want to elect to be taxed as a sub S.
Don’t fret if you already have a LLC treated as a S corporation as there are certain measures that you can take to mitigate this but you are going to need a good tax adviser and small business lawyer to guide you through the process. A S corporation may grant restricted stock and stock options, which may be an alternative.
Debt of the LLC
There are a number of other technical rules differentiating the treatment of S corporations and partnerships. They may not be the decisive issue in determining whether you elect S corporation treatment for your LLC, but they do show that you will need a capable tax adviser. For example, there rules regarding the members’ basis in the company based on debts incurred by the LLC. If your LLC is taxed as a partnership, the members may include a share of the LLC’s debt in their ownership interests in the LLC. For a sub S, in contrast, the members may include a share of the debt of the LLC only to the extent that it is recourse liability, that the member bears the “risk of loss” for the liability. Sounds complicated? That is why you have a tax adviser. But it probably won’t tilt the decision to elect partnership taxation in and of itself.
Distributions of the business property by the LLC
If the LLC has property that it then distributes to members, then whether the transfer is taxable depends on whether the LLC is taxed as a partnership or a S corporation. Distributions from a partnership are not taxable events. Distributions of property by a sub S are treated as sales of that property and the gain is taxable to the owner. The rules favor taxation as a partnership but probably again will not be in and of themselves compelling enough to want to be taxed as a partnership.
Selling and purchasing membership interests
If you are thinking ahead and envision selling membership interests in the LLC, here is a tax rule that you will want to keep in mind. This may come up in the context of a merger or acquisition of your LLC so you need to be aware of the tax consequences of the purchase and sale of membership interests. This is a rule that favors treatment as a S corporation for sellers of membership interests, and treatment as a partnership for purchasers of membership interests.
Say you are selling interests in your LLC, the gain from the sale can be either ordinary income or capital gain—a very big difference. If the assets sold are ordinary income assets like inventory or receivables, then if the LLC is taxed as a partnership, the gain is ordinary gain. If taxed as a corporation, the sale is a capital gain.
From the perspective of the purchaser, the purchase of membership interests in a LLC taxed as a partnership may be more favorable. If purchasers make an election, they can get a stepped-up basis in the assets of the LLC and reducing their tax liability when the assets are sold. With a S corporation, the purchaser does not have the choice.
And let’s say that the LLC redeems the ownership interests of their owners, the other owners receive an inside basis step up.
Tax planning is essential before making an election to be taxed as S corporation
This article was not intended to provide an exhaustive list of differences between taxation of a partnership and taxation of a S corporation. Rather, this article was intended to highlight some of the differences. You may have a good idea of your exit strategy for your new business. If you think that you will be able to take it public in a few years, or that you will stand to benefit for minimizing self-employment taxes, then there may be good reason to make the election to be taxed as a corporation. This article intended to point out some of the countervailing considerations and you should discuss your particular needs with your small business attorney and tax adviser.