I often come across small business owners who’ve made the S-Corp election for their LLC. Usually, after learning about their business, I’m at odds why they choose to do this. I understand by making the election an owner can save on self-employment taxes through a reasonable salary and dividend payments. I believe however, in the majority of instances, the tax savings to the business owners, do not outweigh the legal and tax advantages lost to the LLC on making the tax election. In my opinion for some business owners the short term gains, do not outweigh the potential for long term pains.
An S-Corporation or S-Corp, is not a type of business entity, rather it’s a tax designation. A business can either be an LLC with an S-Corp designation, or a corporation with an S-Corp designation. The business entity “S-Corporation” does not exist.
Below is a list of reasons for you to consider before your LLC elects to be treated as an S-Corporation.
Limited Membership Stifles Growth
To receive the tax break the IRS restricts who can be an owner or shareholder in a business filing under the S-Corp designation. The business must meet strict requirements on the number and type of shareholders.
The IRS limits an S-Corp’s size to 100 shareholders. If you can imagine your business growing beyond 100, maybe hold off on making the election and see how things go.
More importantly, only individuals (people) can be members of S-Corporations. There are exceptions for certain estates, trusts and non-profit organizations. But, a member can’t be an LLC or a corporation. If you have an investor who’s a business and wants a stake in ownership; or if you want to partner with another business, you won’t be able to.
The last membership limiting rule is members have to U.S. Citizens or residents. Also, since the IRS prohibits foreign ownership a non-resident alien cannot be an owner. With the globalization of the economy, it’s just as easy to form a business relationship with someone from New Jersey as it is someone from New Zealand. If you have a skilled individual from another country who you want on your team, you’ll have to choose between him or her and the tax election.
S-Corp Election Profit and Loss Allocation
Tax regulations require an S-Corp to allocate profits and losses among the owners on a one-to-one basis. Allocations are made based on percentage ownership interest in the business, or number of shares held. In contrast, an LLC owners are able to allocate profits and losses in whatever way they desire.
For example, a founding owner who transfers half of the ownership to a new member could receive a greater share of the income from the LLC. An S-Corp must split the profits 50-50.
Also, because of the one class of stock restriction it’s rather difficult for the S-Corp to allocate losses to a specific shareholder. LLCs however, can set out in the operating agreement how to allocate losses to each member.
Restrictions on Stock Ownership
S-Corporations can have only one class of stock, per IRS rules. Although it can have both voting and non-voting shares. Unlike an LLC, there can’t be different classes of investors, entitled to different dividends or distribution rights. Due to this limitation it’s difficult to attract outside investors.
Remember in the eyes of the IRS, an S-Corporation is first and foremost a corporation. Irregardless of your business your registration with the Colorado Secretary of State. Therefore the business must observe all the corporate formalities by Colorado’s corporation statute. On the other hand, Colorado’s LLC laws have few statutory formalities. In fact, some business chose to ignore these formalities, stating so in the operating agreement and agreed to it by the members.
If you’re a business owner who’s inclination is not mind your P’s and Q’s regarding corporate formalities, perhaps making the election is not in your best interests.
Other S-Corp Election Matters
Reasonable Salary. As an owner of an business who makes the S-Corp election you must to pay yourself a reasonable salary. The IRS determines whether the division between salary and dividends must be “reasonable” as determined by the IRS. These salary requirements may be difficult to meet on a year to year basis for companies that may be struggling.
Closer IRS scrutiny. Since amounts distributed to a shareholder can be dividends or salary, the IRS looks closely at these payments making sure the characterization is based on reality. The IRS may re-characterize wages as dividends costing the business money. On the other hand, the IRS may re-characterize dividends as wages, causing the corporation to be liable for employment taxes.
LLCs have Charging Order Protection. Unless the implementation of the S-Corp election is done correctly, a plaintiff or creditor through a court proceeding could re-classify your shares in the business as a C-Corporation and sell your shares during a foreclosure proceeding. Since ownership is tied to shares your business could be sold out from under you. An LLC has “Charging Orders” protection meaning you have to pay the plaintiff or creditor through distributions, but you get to retain ownership of the business.
An LLC can be a pass-through entity without being subject to those restrictions. And although both an S corporation and an LLC are pass-through entities they are taxed under different sections of the Internal Revenue Code, so their taxation is not identical.
Practically speaking, an S-Corporation often provides little or no tax benefits, compared to an LLC taxed as a partnership. On the one hand, the business may not provide enough residual income, after payment of reasonable shareholder salaries, to produce enough of a tax benefit. On the other, a properly structured manager-managed LLC can achieve the same tax benefits.
Before electing S-Corp status for your LLC, carefully consider the potential disadvantages of electing S-Corporation status, as well as quantify realistically projected tax savings. If analysis shows potential tax savings are likely to be enough to outweigh any disadvantages of electing S corporation status; also consider whether a properly structured LLC can achieve the desired tax savings without all of the S-Corp disadvantages. This two-step process often leads to concluding an LLC is a better option than an S-Corp.
Lastly, if shareholders of an S-Corporation decide the decision to be taxed as an S-Corp was ill-advised. The business can’t simply convert to an LLC without triggering a taxable liquidation (payment of taxes). Electing to be taxed as an S-Corps may seem like an easy tax break but could have dire consequences down the road.
Schedule an initial consultation to learn more.
This article is for educational purposes only, and does not constitute legal advice about your case or situation. There may be exceptions to the information outlined above. Please consult an attorney if you have specific questions about your business.