Family-owned businesses are often formed as LLCs. For federal tax purposes, an LLC with two or more members is treated as a partnership unless it elects otherwise. Income earned by a partnership is not subject to a separate entity-level tax under federal tax laws. Rather, net profit or net loss of the partnership passes through to its partners who must report their respective shares on their personal tax returns. It is possible, however, for an LLC to elect to be treated for federal tax purposes as an S corporation. An S corporation is taxed similarly to a partnership in that its income and loss passes through, and is taxed to, the shareholders. Accordingly, as a general matter, an S corporation also does not pay an entity-level federal tax either.
While partnerships and S corporations are both pass-through entities for federal tax purposes, the particular tax rules that apply to these entities can be different.
Because of these differences, an increasingly common structure is for an LLC to elect to be taxed as an S corporation. The rationale for this structure often is to reduce exposure for federal self-employment tax and state entity-level tax. In our experience, however, these perceived benefits are not always weighed against the potential drawbacks of making this election. For instance, electing S status for an LLC can deprive a family business of potentially substantial tax benefits in the event of the death of a member or subsequent buyouts between members (in each case a Section 754 election generally gives a partnership a step-up in the tax basis of its assets to their fair market value which tax savings opportunity is not available in the S corporation context). Further, if the family business anticipates raising capital, an S corporation structure may not be advisable because of the limitations on the issuance of preferred equity (discussed below).
Another significant, and often overlooked, drawback is the difficulty in simply complying with the S corporation requirements. Generally speaking, to qualify as an S corporation, a corporation must be domestic, must not be an ineligible corporation and must have:
(i) only allowable shareholders (certain individuals, trusts, estates and tax exempt organizations),
(ii) no more than 100 shareholders and
(iii) only one class of stock.
Family businesses regularly encounter problems complying with these requirements, even where the underlying entity is a state law corporation. The risks of creating problems is higher in a situation where the underlying entity is an LLC, because the concept of stock does not exist under LLC statutes and there is significant potential for distribution and buy-out rights to violate the one class of stock requirement. For an LLC to meet the one class of stock requirement, the members’ rights to distribution and liquidation proceeds must be identical as determined by its governing documents (i.e., its operating agreement). If the economic deal reflected in the operating agreement is not truly a straight-up, pro-rata agreement, the election could be problematic.
Failure to make a valid S election or to maintain S corporation status can lead to some dire, unintended tax results. If the LLC’s S election is not timely and valid, depending on the incorporation method used, the LLC could inadvertently become a C corporation for federal tax purposes. Similarly, if the LLC’s S election is timely and valid, but it later ceases to be an S corporation because, for example, of failure to meet the S corporation requirements, the LLC would then become a C corporation for federal tax purposes. If the LLC were a C corporation, it would all of a sudden be subject two layers of tax – one at the corporate level on income earned and another at the shareholder when that income is distributed. This double layer of tax would also apply to any unrealized gain in the assets of the LLC, when such assets are distributed or sold and the proceeds distributed.
We encourage family businesses to discuss these and other choice of entity considerations with their advisors when making changes to their governance structure or deciding whether to operate an LLC as a partnership or an S corporation for tax purposes.