Considerations Regarding Tax Burden Allocations Among Members & Owners
In forming your business, considerations regarding control or transferability of interest and the like may be at the forefront of your mind, and tax considerations may be relegated to the backseat. However, choosing between different non-tax options can result in different tax outcomes for your business. You can meet your non-tax options and goals with creative solutions, while at the same time being cognizant of the tax implications of those choices so as to keep the tax burden as low as possible.
Many small business owners choose to form either an LLC or an S Corporation, as both entities provide limited liability for the owners, and also have tax friendly structures, that are especially beneficial during the startup phase. Both entities can avoid the “double taxation” issue associated with C Corporations. However, although both entities are considered “pass-through” entities, many people ask “what’s the difference?”
One of the main differences that should be observed is how profits and losses can be allocated to each owner or member within each entity.
The S Corporation walks, talks, and acts like a regular corporation, but each individual shareholder can report their proportionate share (based on what percentage of shares they own) of the corporation’s gains and losses on their own individual federal and state tax return.
An S Corporation does not permit flexibility in allocations of profits and losses. For example, if the S Corporation has three owners, Owner A [25%], Owner B [25%], and Owner C [50%], allocations of profits and losses must fall to the three owners, proportionate to their share of ownership interest.
All else being equal, should the owners of the S Corporation prefer to allocate gains and losses independent of individual ownership percentage, or desire that allocations of profits and losses be altered at some point during the life of the corporation, then an S Corporation may not be the right choice.
The LLC’s income, losses, and deductions can be passed through to the LLC’s individual members, just as is the case with an S Corporation.
However, unlike S Corporations, LLCs permit their members to allocate gains and losses differently among its members, and are not bound to allocate or distribute by the proportionate share of ownership. For example, utilizing the same hypothetical interest-dispersion as above, if the LLC has three members, Owner A [25%], Owner B [25%], and Owner C [50%], the members are not bound to allocate profits and losses along those lines.
This is especially beneficial when members have varying roles in the business (for example, a passive investor and an on-hands manager may choose, despite their membership interest, to allocate profits and losses disproportionately to the manager).
In choosing whether to form an LLC or S Corporation, one important consideration is whether you want the flexibility of being able to allocate profits and losses to the individual members/owners as you see fit. If one member is an on-hands manager, whose actions directly affect whether the company succeeds or fails, you may want to allocate profits and losses to that member regardless of that member’s actual ownership interest. If an S Corporation is chosen, this flexibility cannot be utilized.