National Paralegal College

Comparing S Corporations and Partnerships

Larry D. Marsh, Esq.

Introduction

Most of the entities formed for use in start-up businesses are so-called “pass-through” entities, meaning that the entity does not ordinarily pay federal income tax on its earnings. Instead, the entity’s owners pay income taxes on those earnings, or deduct the losses if the entity’s business loses money.

Pass-through entities come in two basic “flavors:” 1) those taxed as “S corporations”, and 2) those taxed as partnerships. Which flavor works best will depend upon the circumstances pertaining to the entity’s owners and proposed business.

This article will highlight the differences between S corporations and partnerships. It is not intended to be an exhaustive discussion of the subject. For purposes of simplifying the discussion, this article will assume that a new limited liability company (LLC) is being formed, and the question on the table is whether the new LLC should be taxed as an S corporation or as a partnership.

Basic Similarities

With both the S corporation and the partnership, the owners of the new LLC will be taxed on their respective shares of LLC income. That will be true regardless of whether the LLC distributes any of the money represented by that income to the owners. The “pass-through” and taxation of the income to the owners is separate from their receipt of money from the LLC.

Distributions of money to the owners, to the extent they do not exceed pass-through income, will be generally non-taxable. This is because the income that resulted in the money being available to distribute has been taxable once on the pass-through. This feature of paying tax only once on business income explains most of the popularity of pass-through entities, when contrasted with corporations that pay income tax at the entity level, and whose shareholders also pay tax on money they receive from the corporation as dividends (sometimes referred to as “double taxation”).

And with both, the owners generally will be able to deduct their respective shares of the LLC’s losses, to the extent the owners have “basis” for their ownership interests. In both the S corporation and the partnership, that basis will be increased by money contributed, or loaned, by the member to the LLC and pass-through income, and decreased by money distributed and pass-through losses.

Differences

Although both are pass-through entities, there are significant differences in the income tax treatment of S corporations and partnerships.

Eligibility

For the new LLC to be treated as an S corporation, the LLC and its owners, known as “members,” must make a special tax election. The election must be made before the 15th day of the third month following the date when the LLC is formed to be effective for the LLC’s first tax year. If made later, the election will not be effective until the next January 1 (S corporations, and partnerships, are generally required to use a calendar tax year).

For example, if the new LLC is formed on March 1, the S election must be made not later than May 15 to be effective as of the date of formation.

All members must consent to the election by signing the Internal Revenue Service (IRS) form (Form 2553) used in making the election. The S election is made by filing the completed Form 2553 with the IRS, and the date of filing is the date when mailed (retaining proof of mailing is strongly recommended, e.g., sending by certified mail, return receipt requested).

To make the S election, the new LLC must satisfy certain eligibility requirements:

1. There must not be more than 100 members;

2. Only individuals and certain types of entities, e.g. estates and some trusts, can be members (another S corporation can be a member only if it owns all of the LLC interests, and makes a special election for the LLC to be treated as a qualified subsidiary);

3. None of the members can be a non-resident alien, i.e., membership will be limited to U.S. citizens and resident aliens, and to those certain entities referred to above; and

4. There can be only one class of LLC membership interest, i.e., all member interests must have identical rights to receive distributions. There can be voting and non-voting interests, however.

Once made, the S election will be effective until it is revoked, or until the LLC no longer satisfies the eligibility requirements.

There are no eligibility requirements and no special election necessary for the new LLC to be treated as a partnership. Partnership treatment is the default setting for new LLCs with more than one member.

Flexibility

Due to the eligibility requirement for a single class of ownership interest, if the new LLC is to be an S corporation, it will be limited in how it can structure its membership interests. With the exception of voting vs. non-voting, all interests will have to be identical to each other in terms of their rights to receive distributions and allocations of income or loss. In other words, with the exception of the right to vote, each 1% LLC membership interest must be identical in rights to each other 1% interest.

If the new LLC is to be taxed as a partnership, however, multiple classes of interests, all of them with different rights, can be created. For example, if one member provides most of the money needed, that member can be allocated a disproportionate share of start-up losses, and can have the right to receive priority distributions:

Assume Member A contributes 90% of the cash needed for the new LLC, but agrees to receive only 50% of the total membership interests (because Member B is contributing non-cash assets). Member A can be specially allocated 90% of the losses the LLC expects to incur in its first years of operation, which as a general rule will help offset his other income and reduce his overall income tax bill. Member A also has the right to receive 90% of all distributable cash until he has recouped his investment.

Conversely, if the LLC were to be taxed as an S corporation, Member A would be allocated 50% of the losses and receive 50% of the distributable cash.

Self-Employment Taxes

Pass-through income from a partnership is subject not only to federal income taxes, but also to federal self-employment taxes, which are the functional equivalent of Social Security and federal unemployment taxes applied to, and deducted from, the incomes of wage earners.

Conversely, pass-through income from an S corporation is not subject to federal self-employment taxes.

A note of caution, however: S corporation owners must pay themselves reasonable salaries and incur the Social Security and federal unemployment tax that go with them.

Loss Deductibility

As mentioned above, loss deductions by owners of S corporations and of partnerships are limited to the amount of basis the owners have in their ownership interests. There is a significant difference between the two pass-through flavors, however, regarding how that basis is calculated.

It is not unusual for a start-up business to require financing. The new LLC will need to borrow money, and the owners have been informed by the lender that they must guaranty the loan and be personally liable for its repayment.

If the LLC is treated as a partnership, the amount borrowed will be added pro rata to each member’s basis for his interest. If the LLC is treated as an S corporation, the amount borrowed will not be added to the members’ basis. This is true regardless of the fact that the members will be personally liable for repayment.

Basis often becomes important when a start-up business incurs losses. An example to illustrate:

Assume the following facts: New LLC has two members, A and B. Each member contributes $50 cash to New LLC in exchange for a 50% interest. New LLC borrows $200 from a lender to start its business. In Year 1, new LLC’s business incurs $150 of losses, which are allocated 50% to A and 50% to B.

Scenario 1: S Corporation

A and B each have a basis in their interest equal to the cash they contributed: $50.

A and B each have $75 of loss allocated to them.

Each deducts $50 for Year 1. The remaining $25 of loss each of them is unable to deduct is deferred and carried over until they have sufficient basis to deduct it.

Scenario 2: Partnership

A and B each have a basis in their interest equal to the cash they contributed of $50, plus one-half of the $200 debt. A and B each have a total basis of $150.

A and B each have $75 of loss allocated to them.

Each deducts the full $75 of loss allocated in Year 1.

For the owners of an S corporation to receive an addition to basis for business debt, they must do a “mirror loan” transaction. Instead of making the LLC the borrower, the members would borrow the money from the lender themselves. They would then loan the money to the LLC on the same repayment terms and at the same interest rate. By doing this the members would be loaning the money to the LLC (that they in turn borrowed from the lender), and by doing so would add the amount of money loaned to their basis.

While “mirror loan” transactions are not overly complex and do not increase the personal liability of the owners who are required to guaranty repayment to the lender, the need for them in S corporations creates a trap for the unwary. Sometimes S corporation owners only learn about mirror loans after their loss deductions are disallowed for lack of basis.

Choosing

So now that we have completed a brief review of S corporations and partnerships, which should be chosen for the new LLC? It depends.

Partnership

Treatment as a partnership would be advised if:

S Corporation

Treatment as an S corporation would be advised if:

Conclusion

When it comes to pass-through entities, there is no “one size fits all.” The pass-through “flavors” are not identical. In choosing whether to elect S corporation status or to be treated as a partnership, the circumstances of the owners and the proposed business must be considered in relation to the differences between these pass-through alternatives. An intelligent choice can be made by focusing on how those differences can be anticipated to affect the owners.

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