Pass Through to Greater Tax Savings
Anita S. Wescott
An initial challenge facing a real estate investor or developer is deciding which type of entity will best meet his/her objectives. Care must be taken to consider both the state law ramifications as well as the income tax classification of the entity. While there are numerous entity types available, two “pass-through” entities – an S corporation and an LLC – are popular choices. Although both are “pass-through” entities for tax purposes, there are significant differences that can strongly favor one type over the other.
Shareholders of an S corporation must make an election to be treated as such for income tax purposes.
The corporation remains separate and distinct from its owners, but items of income and expense “pass-through” for tax purposes. There is a limit to the number of shareholders and restrictions on the types of entities that can be shareholders of an S corporation
An S corporation’s tax items must be allocated to shareholders based on ownership percentages. No special allocations are allowed.
A shareholder’s basis in an S corporation does not include any of the corporation’s debt. A shareholder can deduct losses from an S corporation only to the extent of his equity cash investment, accumulated profits, and direct loans by the shareholder to the corporation.
An LLC , or Limited Liability Company, has become one of the most popular choices for doing business. This entity choice combines the “pass-through” tax attributes of a partnership with the limited liability available to corporate shareholders. There is no limit on the number of members and there are no restrictions on the types of entities that can own an LLC interest.
LLC’s have much greater flexibility in allocating tax items among members. A member’s share of the tax items is determined by the LLC agreement and will be respected as long as the allocation has “substantial economic effect” or the member receiving the allocation bears the economic benefit or burden of the item being allocated.
Where there is outside financing, use of an LLC can produce a more favorable tax result than an S Corporation. Borrowing by the LLC is included in the members’ basis on a pro-rata basis to the extent the member is either personally liable for the loans or if nobody is liable, the loan is qualified non-recourse financing. A loan guarantee will create basis for deducting an LLC loss, but it will not for an S corporation shareholder. Debt basis for deducting losses, especially in the early stages of an investment, may tip the decision in favor of an LLC.
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