Limited liability companies are generally treated as pass through entities for tax purposes. By default, the members who work in the business are not considered “employees.” Instead, they pay themselves by distributing profits from the LLC. But because they are not employees, the members also have to pay self-employment taxes. To minimize this tax burden, a small business LLC will often elect S-corporation (S-corp) status for federal income tax purposes. By doing so, the members can become regular W-2 employees. They will still pay some employment taxes on their salary (a portion of which will be paid for by their “employer” as a business expense), but not self-employment taxes on 100% of the business’s profits.
While the S-corp election may offer fiscal advantages depending on each individual’s tax situation, small business owners must recognize that they are trading some of the flexibility inherent in the LLC structure for the more rigid constraints of Subchapter S of the Internal Revenue Code (IRC). Unlike an LLC, which is characterized by few formal requirements, an S-corp is subject to significant limitations regarding its ownership, equity structure, and operation. Failure to strictly adhere to these limitations results in an involuntary termination of the S-corp election, converting the entity to a C-corporation for tax purposes (with the double taxation problems that come with a C-corp), and generally barring a new S-corp election for five years.
This article addresses some of the common pitfalls that may be encountered when an LLC elects to be taxed as an S-corp.
Pitfall 1: Violating Shareholder Eligibility and Quantity Rules
One of the most frequent areas of failure stems from the S-corp rules governing who can be a shareholder and how many shareholders are permitted.
Ineligible Shareholders
Under state law, an LLC is flexible regarding membership. Individuals, corporations, partnerships, and even other LLCs can be members. However, to maintain S-corp status, the LLC must generally have only US individuals (citizens or resident aliens) as shareholders, with limited exceptions for certain estates, trusts, tax exempt organizations, and employee benefits plans.
A common mistake is to allow business entities (such as corporations, partnerships, or other LLCs) to become members of the LLC. For example, I frequently encounter small business owners who believe that they somehow get “more” limited liability protection if they own their interest in one LLC through another entity rather than in their individual capacity. However, doing so would make the LLC ineligible for S-corp taxation.
Read more about what can actually cause you to lose the limited liability protection of your LLC.
Exceeding the 100-Shareholder Limit
While an LLC typically has no upper limit on the number of members it can have, an S-corp can have no more than 100 shareholders. Although a family exception exists (treating spouses, or all members of a family, as one shareholder), exceeding this limit at any particular time during the taxable year results in termination.
Pitfall 2: Creating a Second Class of Stock
The “one class of stock” requirement is arguably the most complex constraint imposed on an LLC that elects S-corp status, often conflicting directly with the flexibility of the LLC structure. An S-corp is treated as having only one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds.
Multiple Classes of Interests
LLCs frequently issue multiple classes of interests with varying economic or voting rights. But if an LLC electing S-corp status issues different classes of LLC interests, this can be deemed the issuance of a second class of stock, terminating the election. For example, a small business owner who wants to have family and friends as silent investors in exchange for a preferential return on that investment would generally require the creation of multiple classes of interest, violating the S-corp rules. However, differences in voting rights alone are disregarded, meaning our family and friend investors could have limited voting rights compared to the founder without running afoul of the rules.
Profits Interests
LLCs commonly issue profits interests to members who provide services (as opposed to a cash contribution) in exchange for their membership interest. These members may be founders of the business or even key service providers that the company wishes to incentivize. A profits interest grants the right to receive a percentage of future profits but not existing capital. However, if the LLC plans to elect S-corp status, a profits interest will be treated as a second class of stock, meaning the members or other service providers will need to buy-in to the company.
Disproportionate Distributions
While an LLC is generally free to structure distributions in the LLC operating agreement as the members see fit, an S-corp must ensure that distributions are proportionate to each member’s ownership interest. A disproportionate distribution generally creates a second class of stock and terminates the S-corp election, though limited exceptions exist for distributions that are mere timing differences or made by mistake.
Pitfall 3: Neglecting the Details and Compensation Rules
Untimely Election
To qualify, the entity must generally make a timely S-corporation election on IRS Form 2553, no more than two months and 15 days after the beginning of the tax year the election is to take effect, with the consent of all current shareholders. Failure to meet this deadline requires seeking relief from the IRS for a late election.
Unreasonable Officer Compensation
Another common pitfall occurs when S-corps attempt to reduce employment taxes by treating payments for services provided by the owners as something other than salary, i.e., cash distributions, payments of personal expenses, or loans. The LLC must treat these payments as salary subject to federal employment tax withholding, and the salary amount must be reasonable and appropriate compensation for the services rendered.
Consequences of Pitfalls and Path to Correction
If an LLC electing S-corp tax status fails to satisfy any of the requirements, the S-corp election is terminated. The business entity then converts to a C-corp for US federal income tax purposes. Consequently, the company is barred from making a new S-corp election for five years, unless the IRS grants consent to an earlier election.
In cases where the termination is inadvertent, the IRS may waive the termination and retroactively restore S-corp status. To qualify for relief, the company must demonstrate that the terminating event was not reasonably within its control or occurred without its knowledge despite due diligence to prevent it, and the company must take steps to correct the condition within a reasonable period. Given the complexity of the requirements and the severity of termination, careful tax planning and continuous monitoring are essential for any LLC seeking to maintain its status as an S-corp.
