Why do pass-through entities such as LLCs taxed as partnerships remain the entity of choice for most closely held businesses?
The primary benefit of operating a business through a pass-through entity, such as an LLC taxed as a partnership, is that the income generated by the business is not subject to double taxation. Instead, the taxable income of the LLC passes through to its members, who receive a Schedule K-1, and is taxed at the individual member level. Shareholders of C corporations, in contrast, are subject to double taxation on dividend distributions and in connection with the sale of the corporation’s assets, unless the “Section 1202 gain exclusion” applies. Another advantage of the LLC structure is that members of the LLC receive a tax basis step-up when they are allocated taxable income, thereby reducing the amount of taxable gain on a subsequent sale of their member interest. For example, the members of an LLC earning $1,000 in 2022, which distributes $350 to pay taxes, will receive an increase in their tax basis equal to $650. Over time, this basis increase can add up and will be very beneficial on a subsequent sale of the business. Because there is no pass-through of gains with the C corporation structure, shareholders do not receive the same benefit.
The LLC/pass-through structure offers a number of other benefits vis-à-vis C and S corporations. Very briefly, these benefits include the following:
- Holders of an LLC interest are given basis credit for debt of the LLC, which potentially allows members to write off losses in excess of their capital investment. Neither C nor S corporation shareholders receive basis credit for entity-level borrowing.
- Generally, LLCs taxed as partnerships afford greater flexibility in planning, as contributions and distributions of appreciated property to and from the LLC are tax-free. In contrast, contributions of appreciated property to a C corporation in exchange for stock must meet the various requirements of Code §351 to avoid being treated as a taxable sale. Code §351 is relatively inflexible, as it requires the contributing group to hold at least 80% of the corporation’s stock immediately after the contribution of such property. Further, nearly all distributions of appreciated property from a C corporation are taxable.
- Members of LLCs can recover tax basis through distributions of cash without triggering dividend tax treatment. A C corporation’s cash distribution is fully taxable regardless of how large a shareholder’s tax basis is in the stock.
- LLCs taxed as partnerships provide more flexibility in connection with the issuance of inventive equity on a tax-favored basis.
- LLCs may have preferred classes of equity, thereby allowing maximum flexibility in distributing cash to the owners. Only common equity is permitted in the case of S corporation.
- The Code and Treasury Regulations generally allow for special allocations of profits and loss to LLC owners. Tax allocations are not available in the case of C corporations, and the rules are much less flexible with respect to allocations made to S corporation shareholders, i.e., on a per share, per day basis.
- The LLC allows for maximum flexibility in distributing cash, allowing for preferred classes of equity. In contrast, the S corporation only permits common equity.
This article touches on only a few of the many issues to consider in determining the optimal business structure. Your choice of entity influences everything from day-to-day operations to taxes and how much of your personal assets are at risk. The analysis is complex, and there is no one-size-fits-all approach. The optimal entity structure for a particular client will be tailored to the unique facts and circumstances surrounding the business, market conditions, the client’s overall goals for operations and a future sale. For more information about structuring your business, please contact Attorney Jason P. Jones in PLDO’s Boca Raton, Florida office at 561-362-2030 or email firstname.lastname@example.org.
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