The distinction between an LLC and an S corporation.
When business owners ponder what entity to choose for their small businesses, the choice is often between an LLC or an S corporation, thinking that they are deciding between two legal entities. Indeed, an LLC is considered a legal entity. However, an S corporation is a tax classification or is perhaps better understood as an election undertaken by a legal entity (it need not be a corporation) that has decided to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
To create an S corporation, you must first form the underlying legal entity (a business entity formed in compliance with state statutes), such as a traditional corporation or an LLC, then you must elect S corporation tax status by timely filing Form 2553 with the Internal Revenue Service. So when we refer to an "S corporation," we are generally referring to a corporation that has elected subchapter S status.
Default Tax Classifications and other possible Classifications
A corporation or an LLC may choose among several tax classifications:
As shown in the table above, a traditional corporation is by default classified as a C corporation. However, it may elect to be treated as an S corporation. The default tax classification for an LLC depends on whether the LLC is a single-member LLC or a multi-member LLC. For single-member LLCs, the default tax classification is that of a sole proprietorship (considered by the IRS to be a “disregarded entity"). For multi-member LLCs, the default tax classification is that of a partnership. However, as in the case of the corporation, the LLC may also elect to be classified under subchapter S.
Does electing S status alter the nature of the underlying entity?
As long as the corporation or the LLC honors the particular requirements necessary to maintain the S status under IRS code sec 1131 (described in more detail below), the S classification will not impact the typical operations or governance of either entity. If the entity is a corporation, it would still have a board of directors. officers, and bylaws, and it would still need to comply with the required corporate formalities such as annual meetings, minutes, and corporate consents. If the entity is an LLC, it would still operate as and exhibit the characteristics of an LLC ---- its membership, management structure, and operating agreement would be that typical of an LLC.
Requirements to maintain S corporation status
While electing S corporation tax status need not fundamentally alter the operations or governing structure of the underlying entity involved, the entity may nevertheless have to alter its operations and governing documents enough to at least abide by the restrictions necessary to maintain subchapter S standing under IRS code §1131, which requires, among other things, that the entity
Have no more than 100 shareholders
Require its Shareholders to be U.S. citizens or legal residents
Permit only one class of stock
Particular concerns for an LLC
Applying the language of §1131 to an LLC can be confusing. For example, the concept of stock does not exist in an LLC. Nevertheless, compliance with §1131 is easy enough. The one class of stock requirement could be determined by looking at each member's rights with respect to distribution and liquidation proceeds under the operating agreement. If the operating agreement does not allow pro rata distributions as required by §1131, for example, the election would be terminated. Consequently, an LLC must exercise extreme care to make sure that the operating agreement does not contain language that violates the criteria required to make an S corporation election. Moreover, LLCs should also make sure that the agreement does not contain any language in any amendments or restatements that would cause an S corporation election to automatically terminate.
Consequences of Losing S Status
The consequences of losing S status are serious: 1) the corporation would not be allowed to re-elect S corporation status until the 5th year after the year in which the termination became effective; 2) the LLC would have to immediately become a C corporation for tax purposes. Unfortunately, the risk of losing S status is high among many LLCs who have opted for boilerplate operating agreements found free on the Internet. Many of these agreements include default language in the tax section that treats the LLC as if it were a partnership. It is wise to remember that the first thing an auditor will do when conducting an audit will be to review the operating agreement. Should the auditor find such language in the operating agreement, the LLC would immediately lose its S corporation status.
Because of the potential risk of losing S status and the resulting expense of resolving the effects of a termination of an S election, it is therefore important that all LLCs who have elected S corporation treatment review their operating agreements with their legal advisor to ensure that they are in compliance with §1331.
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The information provided in this article is for general informational purposes only and should not be construed as legal advice or opinion. Readers are advised to consult with their legal counsel for specific advice.