In addition, all states have now enacted some form of legislation authorizing a new kind business entity - Limited Liability Companies (LLCs for short). There's been a lot talk about how these entities combine the best of corporations and partnerships, such as the pass-through tax treatment with limited liability.
Advantages of the S Corporation
Much like a traditional corporation, you enjoy the same advantage of combining limited liability without tax at the entity level currently with your S corporation. Your personal assets are not at risk because of the activities or liabilities of the S Corporation (unless, of course, you pledge assets that personally guarantee the corporation's debt). At the same time, your S Corporation generally does not have to pay corporate level income tax. Instead, the corporation's gains, losses, deductions, and credits are passed through to you and any other shareholders, and are claimed on your individual returns. The fact that losses can be claimed on the shareholders' individual returns (subject to what are known as the passive loss limits) can be a big advantage over traditional corporations.The Small Business Job Protection Act of 1996 has made major changes to allow the rules governing S Corporations to be more flexible. S corporations can now have 75 shareholders instead of just 35 and qualified tax-exempt entities such as qualified pension, profit-sharing and stock bonus plans can be shareholders. In an important change from an estate-planning perspective, electing small business trusts where all beneficiaries are individuals, estates or charitable organizations holding contingent remainder interests can now be shareholders. S Corporations can now have C and S corporations as subsidiaries. And there are a number of other helpful changes, such as making S Corporations eligible for capital gains treatment for subdivided real property.
Advantages of an LLC
Even with the changes, however, LLCs have a number of distinct advantages over S Corporations for many business. There are no limits on the number or kinds of shareholders. Since LLCs are not restricted to one class of stock, there is greater flexibility to allocate gains, loss, deductions and credits. Furthermore, LLCs have more estate planning flexibility and there are other technical advantages that can make a bottom-line tax difference.
On the other hand, converting an established S Corporation to an LLC requires liquidation of the corporation, which is subject to tax at both the corporate and shareholder levels. This tax cost may make conversion impractical. While there is a legislative proposal that provides for the elimination of this obstacle to tax-free conversion as part of a tax simplification plan, the fate of this proposal in Congress remains very uncertain. Through proper tax planning, you can take advantage of recent changes while maintaining sufficient flexibility to be able to respond to future developments.
In light of these tax changes, we recommend that you take this opportunity to re-examine the tax ramifications of the current structure of your business. We would be pleased to help you evaluate all the relevant factors to determine whether an LLC would be advantageous for you now or possibly in the future. We can also help you maximize the benefits of the changes in the S corporation rules in the continued operation of your business, should an S-Corporation election be the best for your situation.