There is one thing to add to the standard list of considerations when forming a new entity and choosing between either an LLC that is taxed under partnership rules or an S Corporation. It has to do with the tax impact on the owners if the venture fails and the value of the assets is not sufficient to pay the amount owed to its creditors. The resulting debt forgiveness could result in a significant tax liability.
Under Section 61 of the Internal Revenue Code the discharge or cancellation of indebtedness is included as income (“COD Income”). However, Section 108 excludes COD Income if the discharge occurs when the taxpayer is insolvent (“Insolvency Exclusion”). As between an LLC and an S Corporation, there is a difference in how the Insolvency Exclusion is applied.
Keep in mind when considering the difference that COD Income is typically triggered when the entity, the LLC or S Corporation, becomes insolvent. Having chosen an entity with limited liability, the members or shareholders may lose their investments but (barring personal guarantees) are not typically rendered insolvent themselves if the venture fails. So what’s the difference between the LLC and the S Corporation?
With an LLC, insolvency is measured not at the entity level but at the member level. This means that no Insolvency Exclusion is available unless the member is personally insolvent which, again, will typically not be the case. COD Income will flow to the members unless one of the other exclusions under Section 108 applies.
With an S Corporation, on the other hand, insolvency is measured at the entity level. This means that the Insolvency Exclusion will apply if the corporation is insolvent even though individually the shareholders are not. No COD Income will flow to the shareholders.
This difference is an important consideration when selecting a form of ownership for the entity. There will be times when the LLC form will be preferred for non-tax reasons; in these cases, using the LLC form but electing to have it taxed not as a partnership but as an S Corporation might fit nicely. Something to think about.
If you have any questions about how the information in this article may affect you or your business, please contact Ron Todd at firstname.lastname@example.org or (608) 257‑2281 or your Stroud attorney.
DISCLAIMER: The information in this article is provided for general informational purposes only, is not necessarily updated to account for changes in the law, and should not be considered tax or legal advice. This article is not intended to create, nor does the receipt of it constitute, an attorney-client relationship. You should consult with your own legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.