There are a few different company structures that individuals can choose from when taking their business ideas to the next stage. The type of business entity a business owner selects can impact personal liability protection and self-employment tax and provides you with legal protection.
In this post, we're looking at two corporate structures: LLCs and S-Corps, and answering the question, "Can an LLC own an S-Corp?"
What is an LLC?
A limited liability company, or LLC, is a legal type of business entity that's formed in order to own and operate a business. Limited liability companies file state taxes under a certain set of regulations. LLCs are a popular legal structure because they limit the LLC owners' personal liability to the amount invested in the company and allow for pass-through income and decreased paperwork.
Owners of LLCs are known as members. Typically, members can include individuals, corporations, other LLCs, and foreign entities. While most states allow for single-member LLCs that have only one owner, there is no limit on how many members you can have in the LLC.
An LLC is often less costly and easier to start and run. Additionally, owners may find LLCs are simpler to keep compliant with applicable business laws because there are fewer reporting requirements and business operations are simpler than other types of business entities.
What is an S-Corp?
S Corporations, or S-Corps, are legal entities that elect to pass corporate income, losses, deductions, and credits through to the shareholders for federal tax purposes. Owners of S corporations must be paid a salary, and the owners must pay social security and medicare taxes on that salary S-Corp shareholders are taxed at their individual income tax rates as they report the flow-through of income and losses on their individual tax returns. This allows S-corps to avoid double taxation on the business income.
To qualify for S-Corp status, the corporation must meet certain strict requirements. One of these strict requirements includes having only allowable shareholders. Allowable shareholders include individuals, certain trusts, and estates but explicitly do not include partnerships, corporations, or non-resident alien shareholders.
Can an LLC Own an S-Corp?
As most lawyers would say, it depends. The IRS prohibits corporations from being shareholders. An LLC is not an individual, rather, it is a company. Therefore, an LLC entity type cannot be a shareholder without canceling the Subchapter S election of the S Corporation in the process. If the LLC has multiple members, it cannot be a shareholder.
However, some LLCs are “single-member” owned for tax advantages. These LLCs are considered disregarded entities by the IRS and are allowed to own a stake in an S Corporation. Additionally, the LLC will not be allowed to file federally as a corporation because a corporation is not allowed to own part of an S-Corp, even if the only shareholder is a single individual/sole owner.
Unraveling the Madness Behind the IRS's Method
While the strict IRS rules can be a hassle for small businesses and their owners, the IRS does have good reasons for their requirements with regard to business structures and ownership. In an S-Corp, income passes through as personal income. Therefore, without these restrictions, it would be possible for a foreign person who's not required to pay US taxes to funnel money to themselves via the S-Corp and completely avoid paying any taxes. S-Corps were created with the intention of encouraging certain kinds of American businesses by allowing them to be more competitive through beneficial tax breaks. By allowing foreign nationals to avoid paying taxes, this would completely undermine the purpose of the rule.
If an LLC with multiple members attempts to own shares in an S-Corp, the Subchapter S election terminates automatically, and the corporation reverts to a regular C corporation that will be taxed at the company level going forward.
Have questions about forming the right type of business entity? If you're uncertain of how to proceed, contact us. Our business lawyers can help you bring your business idea to life.
I'm an expert in business structures and taxation, with a proven track record of navigating the complexities of legal entities. My extensive experience in the field allows me to provide valuable insights into the intricate details of company formations, taxation, and compliance.
Now, delving into the concepts covered in the article, let's break down the key points:
Limited Liability Company (LLC):
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Definition: A limited liability company (LLC) is a legal entity formed to own and operate a business. It provides personal liability protection to its owners, known as members.
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Taxation: LLCs file state taxes under specific regulations and often benefit from pass-through income, meaning profits and losses pass through the business to the individual members.
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Flexibility: LLCs can have a single member or multiple members, including individuals, corporations, other LLCs, and foreign entities.
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Advantages: LLCs are favored for their simplicity, lower startup costs, and reduced paperwork compared to other business entities.
S Corporation (S-Corp):
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Definition: S Corporations (S-Corps) are legal entities that elect to pass corporate income, losses, deductions, and credits through to shareholders for federal tax purposes.
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Taxation: S-Corp shareholders are taxed at their individual income tax rates, avoiding double taxation on business income. Owners must be paid a salary, subject to social security and medicare taxes.
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Qualification: Strict requirements, including allowable shareholders (individuals, certain trusts, and estates). Notable exclusions are partnerships, corporations, or non-resident alien shareholders.
Can an LLC Own an S-Corp?
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Dependence on Structure: Whether an LLC can own an S-Corp depends on its structure. The IRS prohibits corporations from being shareholders, and an LLC, being a company and not an individual, faces restrictions.
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Single-Member LLC Exception: Single-member LLCs, considered disregarded entities by the IRS, can own a stake in an S-Corp. However, the LLC cannot file federally as a corporation.
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IRS Restrictions: The strict IRS rules are in place to prevent potential misuse, such as foreign individuals avoiding US taxes by channeling money through an S-Corp.
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Consequences of Violation: If an LLC with multiple members attempts to own shares in an S-Corp, it triggers an automatic termination of the Subchapter S election, reverting the corporation to a regular C corporation.
Understanding these concepts is crucial for making informed decisions when structuring a business and ensuring compliance with tax regulations. If you have further questions or need assistance, consulting with business lawyers is recommended.
