Choosing Between an S-Corp and LLC?

Many clients that desire to form a new company are eager to understand the practical differences between an S-Corp and a limited liability company.  For most business models, the differences are slight and perhaps immaterial.  Both companies offer liability protection to the individual owners, the opportunity to be taxed as a partnership (and thus avoiding the double taxation of a C-Corp) and are fairly friendly when it comes to adding new partners or growing your business. 

But the one question that I always pose to a client choosing between an S-Corp and LLC is whether the company will own real property.  If so, an LLC is almost always the way to go.

Although the IRS allows taxpayers to generally treat an S-Corp as a partnership for purposes of pass through income, the S-Corp is still, by its very nature, a corporation.  As such, an S-Corp is subject to the same tax rules as a C-Corp when it comes to the transfer of property into and out of the company.  These rules may pose potentially dramatic financial consequences to an unsuspecting owner.

The tax treatment of transfers of property to an S-Corp starts out similar to transfers of property to an LLC.  Assume you own 100% of a rental property with a tax basis of $500,000 that is now worth $1,000,000.  For simplicity purposes, assume the property has not been depreciated.  You decide to transfer that property to a wholly-owned entity for liability reasons.  Regardless of whether you choose to form as an S-Corp or LLC, when the property is transferred, the company takes ownership of the property with your $500,000 basis and you do not pay any tax at the time of transfer on the difference between basis and fair market value.  Straightforward, right?

But now let us assume that property is subject to a $600,000 mortgage.  You transfer the property to your new company.  If you formed an LLC, the transaction is unlikely to result in any tax consequences given the interplay between Internal Revenue Code sections 722, 731, and 752 which pertain to transfers to and from partnerships.   

However if you formed an S-Corp, then the transfer is subject to corporate tax code provisions including Internal Revenue Code section 357(c).  Under Section 357(c), the transfer results in the company “paying” you $600,000 in exchange for property with a transfer-basis of $500,000. The result being $100,000 in taxable income (in the form of debt relief) to you for simply transferring your property to your wholly-owned company!  

If you think that is bad, the consequences of getting property out of an S-Corp are even worse.  

Let us use the same property discussed above, with a basis of $500,000 and fair market value of $1,000,000.  Regardless of whether you hold the property as an S-Corp or LLC, if the company sells the property to a third party, it would expect to receive a $500,000 taxable gain.  Again, pretty straightforward.

But what if you simply want to re-title the property in your own name?  Or transfer the property to another wholly-owned company or a trust?  If you held the property in an LLC, there would not be any income tax consequences of doing so.  You (or your new company or trust) would likely take title to the property with a $500,000 basis and the company itself would not recognize any gain on the transfer. 

However, if you held the property in an S-Corp, the tax consequences of transferring the property back to yourself are quite different.   Under IRC Sections 311(b) and 336, whenever a corporation distributes property to a shareholder, the corporation is treated as having sold the property for its fair market value.  Thus, the corporation recognizes a taxable gain whenever it distributes appreciated property to a shareholder.   Using our example above, if an S-Corp distributes a property having a basis of $500,000 and a fair market value of $1,000,000 back to the shareholder, the company is treated as though it sold the property for fair market value.  This triggers a $500,000 taxable gain to the company, which, under the favorable single-level taxation rules, means the owner incurs a federal tax bill of $100,000 plus, depending on where the property is situated, state taxes.   

What about if the property that has gone down in value?  Assume your property has a basis of $500,000 but its current fair market value is only $400,000.  If the company distributes the property back to its shareholder, it would appear that company did not receive any gain on the “sale”.  The IRS has a rule for that too.

Section 1250 requires that whenever a property is distributed it must capture previously uncaptured depreciation.  Thus, if the company owned the property for 10 years before distributing it back to the owner, the IRS would treat the basis as $500,000 less 10 years’ worth of depreciation (about $180,000).  The sale now is viewed as a $400,000 sale less $320,000 in adjusted basis, for a taxable gain of $80,000.   

As we can see, there is very little that can be done to avoid the tax consequences to the owner once property has been transferred to a corporation.  Thus, it is imperative to choose the right entity initially for purposes of owning real property.  From a tax perspective, the choice would favor using an LLC.