Jimmy Belobraydic - Journal Record
Feb 14, 2023
Limited liability companies are a common business structure for small businesses and entrepreneurs. They offer personal liability protection and ownership flexibility.
Limited liability companies are a common business structure for small businesses and entrepreneurs. They offer personal liability protection and ownership flexibility.
However, the way they are taxed by the federal and state government can vary. The IRS will treat an LLC as a corporation, partnership or part of the owner’s tax return depending on the LLC’s election, number of members and type of members. S Corporations have become a popular recommendation by accountants since 2004 when the IRS simplified the process of electing S Corporation status for tax purposes.
The reasons for the recommendation can vary, but often it’s to reduce Medicare and Social Security tax, to pay owners wages, or to navigate the Internal Revenue Code more easily. While an LLC that has elected to be an S Corporation has advantages, there are also considerations to be made. Outlined below are some common items to consider before making the election:
• LLC operating agreements may invalidate the S election or be unsuitable for S Corporation status. Most operating agreements that don’t consider S Corporation status have references to capital accounts and partnership regulations under Sec. 704(b), which can result in disproportionate distributions, income and deductions, which are not allowed as an S Corporation.
• S Corporations do not provide the flexibility of allocating income and deductions out of proportion to the shareholders’ stock ownership percentage. This can be a problem when seeking investors who seek out preferred return of capital or companies seeking multiple rounds of investment funding.
•The inside tax basis of assets in an S Corporation cannot be adjusted upon a shareholder’s death, acquisition of stock or property/cash distribution. However, partnerships can adjust the inside tax basis of assets with an election under Sec. 754 for a partner’s acquisition, death or certain distributions. This is an important item to consider when looking at succession planning.
•S corporation distributions of property to shareholders may result in gain recognition and is treated as a sale of property at fair market value. Partnerships don’t generally recognize gain on property distributions.
LLCs and their members should carefully weigh the pros and cons of becoming an S Corporation. While the S election process may be simple, undoing the election can be complex, time-consuming and expensive. It’s best to involve a tax advisor and legal counsel in the decision-making process.
Jimmy Belobraydic, CPA, is tax senior manager at Arledge, the largest locally owned accounting firm in the Oklahoma City metropolitan area. Arledge is a recognized leader in the accounting industry offering practical solutions in the areas of tax planning, auditing, consulting, accounting advisory services and client accounting.