Special Counsel
I hate LLCs that make elections to be treated as S corporations. I mean I really hate it. It infuriates me. Since it’s become possible for LLCs to elect S corporation treatment, I don’t think I’ve ever seen a single instance where I felt it was justified.
A Little Background
S corporations have been around for quite a while. Since 1958, in fact, when the provisions of subchapter S were first incorporated (no pun intended) into the Internal Revenue Code. The goal of the statutes giving rise to S corporations was to give shareholders of closely held businesses the combined advantage of the protection from business liabilities available to shareholders of corporations, with the passthrough income tax treatment available to partners of partnerships. As a result of an S corporation election, the electing corporation is not required to pay income taxes so long as the shareholders of the corporation report their own allocable shares of corporation taxable income on their own individual tax returns. If you’ve ever heard of the concept of the double taxation of corporation profits, that concept generally doesn’t apply to S corporations.
There are a number of requirements that must be met for a corporation to be eligible for an S election, and these requirements have changed slightly over time. Under current law a corporation is “eligible” if:
- It has no more than 100 shareholders,
- All shareholders are individuals (with some exceptions for trusts and estates, and tax-exempt organizations),
- No shareholders are nonresident aliens of the U.S., and
- There is only one class of stock (though differences in voting rights alone among multiple classes of stock are allowed).
Once articles of incorporation are filed, an S election is simply made by filing Form 2553 with the IRS (the form is available by download through the IRS’s website). From there, profits and losses of the company are allocated among the shareholders according to their percentages of stock owned. For example, if Corporation X has 100 shares of stock issued and outstanding to individuals A (25 shares) and B (75 shares), A would be required to report 25% of X’s annual profits or losses on A’s tax return, and B would be required to report 75% of X’s annual profits or losses on B’s tax return. Similarly, distributions from the corporation are made according to each shareholder’s percentage ownership.
In the case of partnerships, the partners have tremendous flexibility in determining how profits and losses are allocated among themselves, and how money and assets are distributed. Partnerships can provide certain partners with rights to the first earnings of the partnership, preferential rights to certain types of income, expense, tax credit, distributions, etc. However, at one time, a major drawback of the partnership (and still exists in the case of some types of partnerships) was that the partnership lacked the limited liability afforded to shareholders of a corporation. This liability protection shielded corporate shareholders from personal liability for corporate debts.
Back in “the day” whether a business entity (other than a corporation) was taxed as a partnership or corporation depended on whether the business entity had certain characteristics. A business entity, like a limited partnership, could have limited liability, but if it had too many other characteristics typically associated with a corporation, the business entity would be taxed as a corporation. One reason for the creation of the limited liability company was to meld the limitations of liability afforded corporations, with the economic flexibility afforded partnerships. Over time, the IRS has allowed certain types of business entities to simply elect if they wanted to be treated as a corporation, rather than relying on an analysis of what characteristics the business entity maintained. By default, a limited liability company with more than one member is taxed as a partnership, so an election must be made if corporate taxation is preferred.
Why I Hate S Elections for LLCs
By electing to treat an LLC as a corporation for tax purposes, effectively the prerequisite to making the S election, the members of the LLC are losing all of the economic flexibility LLC’s were created for in the first place. So, my response to people who suggest making the S election for an LLC is “if you want an S corporation, let’s form a corporation – not an LLC.” Forming a corporation is after all and in my opinion, the more straightforward approach. If you want a dog that looks like a dalmatian you can buy a hyperactive, white dog and paint black spots on it, or you could buy a dalmatian. But my reasons for wanting to form a corporation rather than an LLC go beyond this.
For example, lay persons often don’t understand the importance of distinguishing between an LLC and an S corporation. On more than one occasion I have begun working with an LLC on tax matters, only to discover later on that an S election was previously made for the business entity. If the client understood the significance of the difference and had pointed out that an S election were made, time and efforts would not have been wasted. Also, all limited liability companies should have an operating agreement in place. The operating agreement addresses many aspects of the limited liability company, including issues of control, member rights and responsibilities, allocation of profits and losses, the distribution of cash and assets, and liquidation of the company, among a host of other issues. Operating agreements are usually drafted with partnership tax principals in place, not corporate or S corporation principals. If, for example, parity among members does not exist with respect to economic matters, a second class of stock might be created. For example, the operating agreement might require that capital accounts be maintained for all members, and that liquidating distributions be made in accordance with positive capital account balances. This requirement may not confer identical rights to distributions and liquidations required of S corporations, thereby invalidating the S corporation election, resulting in a C corporation, and subjecting corporate profits to two levels of taxation. The worst outcome possible!
Some persons have proposed that an LLC is less expensive to create and easier to administer than a corporation. I disagree on both counts. The costs of forming an LLC that would be eligible for an S election, and a corporation are generally the same, and frequently the corporation is actually less expensive to form, particularly where an operating agreement must be tailored for corporate tax concepts. From an administrative standpoint, at least in Colorado, maintaining good standing for both entities requires virtually the same annual filing with the Colorado Secretary of State. An accountant recently and correctly pointed out to me that the corporate statutes in Colorado require corporations to hold annual meetings of their members, while the LLC statutes are silent on this matter, but this misses a hugely important point. All business entities should conduct some type of annual meeting and maintain records of such meetings, even entities owned by a single person. Annual and regular meetings of members and shareholders evidence that business and corporate formalities for all entities are being observed and respected and will go a long way in establishing the legitimacy of the business entity, particularly if the entity is attacked as a sham by a potential creditor.
Of course, I realize there might be some odd exceptions to these rules – but I haven’t encountered any yet. Also, please keep in mind that I’m not advocating for the use of S corporations in all cases over LLCs when choosing an appropriate form of business. Simply, I argue that if an S corporation is determined as the appropriate form of business, don’t form an LLC that elects S corporation status. Form a corporation that elects S corporation status. Finally, my usual disclaimer applies that this article is not intended to be an expansive and detailed analysis of the law. If you have any questions, please don’t hesitate to contact me.