Today many companies are incorporated as limited liability companies (“LLC”). The IRS does not recognize the LLC as a taxpayer classification for federal tax purposes. For tax purposes, by default, an LLC with one member is treated as a sole proprietorship and an LLC with more than one member is treated as a partnership, unless it elects otherwise. Net profit or net loss passes through to its members who must report their respective shares on their personal income tax returns. As a pass-through entity, an LLC is not subject to tax at the entity level and, as such, avoids double taxation. However, an LLC can elect to be taxed as an S corporation.
Both entities share the characteristic of passing-through taxation of income and losses to the owner(s) and both share limited liability protection. However, each has some distinguishing features. Generally, an S corporation election is chosen to reduce exposure for federal self-employment tax and state entity-level tax. However, the benefits of an S corporation election can be accompanied by some unanticipated drawbacks. First, an S corporation election is accompanied by compliance requirements and restrictions that the entity:
- be a U.S. corporation
- have no more than 100 shareholders
- shareholders can only be individuals, certain trusts, and estates
- non-resident aliens, partnerships, corporations cannot be shareholders
- have only one class of stock
Complying with the S corporation election requirements entails thorough planning for an LLC because generally an LLC does not have stock. As such, the distribution and buy-out rights can violate the one class of stock requirement. In order to meet the one class of stock requirement, an LLC's members' rights to distribution and liquidation proceeds must be identical under its operating agreement.
Failure to make a valid S corporation election or to maintain the election can have unintended tax consequences. For instance, if the LLC’s S corporation election is not timely and valid, the LLC could inadvertently become a C corporation for federal tax purposes. Furthermore, if the LLC’s S corporation election is timely and valid, but the LLC later ceases to be an S corporation for any reason, the LLC would then become a C corporation for federal tax purposes. As a C corporation the LLC would be subject to double taxation, which would apply to unrealized gain in assets such as during the distribution or sale of assets and when proceeds are distributed.
Second, an S corporation election can deprive an LLC of certain tax benefits under IRC 754 that allows a partnership a step-up in the tax basis of its assets to their fair market value in the event of the death of a member or subsequent buyouts between members. Third, an S corporation election may not be advisable when raising capital because of the limitations on the issuance of preferred equity.