Considerations in determining whether to elect S corporation or LLC status.

• Author: Altieri, Mark P.
• Position: Limited liability company

The last few years have produced all explosion of legislation permitting the formation of limited liability companies (LLCs). Most states now permit the formation of LLCs and/or limited liability partnerships (LLPs).(1)

LLCs are generally taxed under subchapter K (governing the Federal income taxation of partnerships). The Federal income tax classification of an LLC as a partnership, as opposed to an entity taxable as a corporation, hinges on Regs. Sec. 301.7701-2, which provides that all unincorporated entity will be classified as a corporation if it possesses more corporate than noncorporate characteristics. For an entity to be taxed as a partnership, it must possess less than three of the following corporate characteristics"(1) continuity, of life, (2) centralized management, (3) limited liability and (4) free transferability of interests.

Limited liability, is inherent in an LLC; thus, the analysis turns on which, if any, of the additional three attributes the LLC has. Generally, LLC members will desire (or actually have) centralized (i.e., representative) management (2); thus, the LLC will have limited liability. and centralized management and, therefore, must ensure that continuity of life and free transfer ability of interests are lacking. Rev. Proc. 95-10(3) provides guidance on this issue and has applied to LLCS the ruling criteria used for state law partnerships.(4)

Many a small business desiring limited liability will be able to elect to be either an S corporation or an LLC taxable as a partnership, if it is owned by at least two and fewer than 36 individuals.(5) Which form of entity should be chosen? Although the taxation of S corporation and partnership operations is generally similar (i.e., both are "flowthrough" or "conduit" entities for Federal income tax purposes), significant differences exist between the Federal income taxation of S corporations and partnerships, especially in the areas of financing, formation, restructuring, distributions and entity liquidation,(6) and are the subject of this article.

Entity Formation

Contributions of Appreciated Property

Often, appreciated property is transferred to a newly formed entity as a capital contribution. In the case of such a contribution to an S corporation, to obtain tax deferral, Sec. 351(a) requires that the transferor shareholder, along with all other shareholders making contemporaneous property contributions, must "control" the corporation immediately after the transfer. Under Sec. 368(c), "control" is defined as 80% or more of all classes of stock, including voting stock.(7)

In the case of an LLC taxable as a partnership, there is no control requirement, the contributing partner (whether a 1% or a 99% owner) recognizes no gain, under Sec. 721 (a).

Example 1: K and J are equal owners of ABC Co., which they formed several ears ago. K contributes currently a significant amount of highly appreciated property to ABC for an additional 10% of the issued and outstanding equity interest. If ABC is an S corporation, K will recognize the appreciation on the contributed property, because he is not in Sec. 368(c) control of the entity immediately after the contribution. If ABC is an LLC taxable as a partnership, the contribution is tax free under Sec. 721(a).

Contributions of Liability Property

When encumbered property is contributed to an S corporation and the transferee assumes the underlying liability, the contributing shareholder recognizes gain under Sec. 357(c) to the extent the liability assumed exceeds the tax basis of all property contributed by that shareholder.

In the case of an LLC taxable as a partnership, the contributing owner recognizes gain to the extent his liability is relieved. The relieved liability constitutes a deemed cash distribution to that owner under Sec. 752(b); actual or deemed cash distributions in excess of the owners outside basis in his interest trigger gain recognition under Sec. 731(a)(1).

Example 2: K and J are equal owners of NEWCO. In exchange for his interest, K contributed encumbered property with a fair market value (FMV) of $100,000 and basis of $25,000 and subject to a $40,000 liability that NEWCO assumed and K and J secondarily guaranteed.

If NEWCO is an S corporation, K would recognize a $15,000 gain ($40,000 - $25,000); NEWCO is an LLC taxable as a partnership, at the time of contribution, K establishes a 25,000 tax basis in his NEWCO interest against which he is deemed to have received a$20,000 cash distribution ($40,000 X 50%, the amount of the liability he is deemed relieved of@. Because K's basis in NEWCO exceeds the deemed cash distribution, the $20,000 triggers no gain recognition. Ks outside basis is reduced from $25,000 to $5,000 by absorbing the distribution.

Receipt of Ownership Interest for Services

Sec. 83 triggers gain recognition to a service provider (SP) who receives an equity interest. in the case of a newly incorporated entity, this result may cause more problems than mere taxation to the SP-shareholder.

Sec. l351(a) requires that the controlling shareholders of a newly incorporated entity must have received their stock for "property" for the exchange to be tax-deferred. Services are not property for this purpose, a shareholder who receives stock solely for services is not a member of the controlling shareholder group necessary to effect tax-free treatment under Sec. 351 Apart from current income taxation to the SP-shareholder, an ancillary result would be to generally deny Sec. 351 treatment to all shareholders if the SP-shareholder receives more than a 20% stock interest in exchange for services.

In the case of an LLC taxable as a partnership, the tax results depend on whether the SP-partner received a share of current capital(9) or merely a right to participate in future profits. Sec. 721 and Pegs. Sec. 1.721-1(b)(1) indicate that an SP-partner's receipt of the right to participate only in future partnership profits does not trigger current income taxation. The consensus appears to be that the receipt by an SP-partner of a profits interest will not trigger current income taxation, particularly if there is no long operating history of the underlying business that would allow for a reasonable valuation of such an interest.(10) The IRS has provided significant guidance in this area in Rev. Proc. 93-27,(11) in which an individuals receipt of a profits interest in exchange for services to or for the benefit of a partnership (as a partner or in anticipation of becoming one) generally does not trigger gain recognition to either the partner or the partnership.

Example 3: J and K form NEWCO as equal owners. J contributes equipment with an FMV of $100,000 and a zero basis. K receives his interest in return for professional services rendered in the formation of NEWCO and to be rendered in its new business.

If NEWCO is an S corporation, K receives stock with an FMV (under a hypothetical liquidation@ of at least $50,000 that win be currently taxable to him if the stock is unrestricted. The value of the stock taxed to K will be ordinary income, although NEWCO will have an offsetting deduction for the compensatory payment.(12) In J's case, because he is not in control of NEWCO immediately after the transfer, Sec. 351 does not apply; J will recognize $100,000 gain.

If NEWCO is an LLC taxable as a partnership, Sec. 721(a) protects J from income recognition. Additionally, if K receives a right only to share in 50% of NEWCO's future profits, and has no right to share in J's $100,000 capital contribution in the event of a liquidation, he will not recognize gain currently.

Operational Tax issues

Entity Debt and Outside Tax Basis

The effect of entity-level debt in the computation of an owner's outside basis in his interest is another...