A Limited Liability Company (LLC) is a type of business entity structure that provides the tax benefits of a sole proprietorship or partnership, combined with limited liability protection. An LLC limits an owner’s personal liability for debts, lawsuits, and obligations generated by the business to that owner's capital investment in the company only.
An S-corporation, on the other hand, is federal tax status provided for under SubChapter S of the Internal Revenue Code (“I.R.C.”). S-corporation status provides an incorporated business entity with the tax benefits of a sole proprietorship, partnership, or LLC and avoids the double taxation that C-corporations are subject to.
Both LLCs and S-corporations offer businesses very useful advantages. But business owners are often confused over what assets these business entities can own.
One question that comes up frequently is whether an LLC can own shares in an S-corporation? The answer to this question is YES. But, only if the LLC is a single-member LLC that has elected to be treated as a disregarded entity for federal income tax purposes.
Read further to find out why.
S Corporation vs. LLC
To understand why a single-member LLC can own shares in an S-corporations when other such entities cannot, we must first review what characteristics LLCs and S-corporations have as taxable entities.
What is an LLC?
An LLC is a type of business entity structure that is formed at the state level and provides the tax benefits of a sole proprietorship or partnership, combined with the limited liability protection of a corporation.
LLCs are pass-through entities for tax purposes, meaning that their income flows through to their owners, where it is taxed at the personal income tax level. Thus, avoiding any taxation at the corporate level.
An LLC is considered a separate legal entity from its owners. As such, it provides its owners with limited liability protection from debts, lawsuits, or other responsibilities generated by the business, while also providing the tax benefits of sole proprietorship or partnership.
An LLC is subject to self-employment taxes, but can elect to be taxed as a disregarded entity (single-member LLCs only), partnership, C-corporation, or S-corporation.
How is an LLC Formed?
An LLC is formed at the state level by filing Articles of Organization with the Secretary of State. You must also identify a registered agent for your LLC. Your registered agent will provide a legal address (within the state) where there will be someone available during normal business hours to make possible legal service of process in the event of a lawsuit.
Though it is not a requirement for a Wyoming LLC, you should also draft an LLC Operating Agreement in order to specify the voting rights, ownership shares, duties, and obligations of your LLC's members.
If your LLC has two or more members, or in other words, if yours is a multi-member LLC, you will need to file an annual informational income tax return via IRS Form 1065, U.S. Return of Partnership Income, and issue a Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits to each of its members.
Additionally, depending on which tax status you elect for your LLC, you may be required to make quarterly estimated tax payments for your LLC, in addition to your personal income tax returns.
Other ongoing responsibilities for your LLC will include:
- Filing an annual report with the Secretary of State; and
- Paying the annual LLC License Fee
Otherwise, a Wyoming LLC has no other ongoing maintenance requirements to be concerned with.
What is an S-corporation?
Rather than a type of business entity, an S-corporation is a federal tax status that certain incorporated business entities can elect. By electing S-corporation status, the business is treated as a flow-through entity for tax purposes. This means that the business's profits and losses flow through to its shareholders, where it is taxed at the personal income tax level and not the corporate level.
Thus, one advantage of an S-corporation is that it receives more tax benefits than a C-corporation because its taxes pass through to its shareholders' personal tax returns, avoiding the double taxation that C-corporations are subject to. Furthermore, if all corporate formalities are followed, S-corporation status typically provides a high level of personal liability protection for its owners, similar to a C-corporation or LLC.
How is an S-corporation Formed?
Forming an S-corporation is an involved process. Here are some of the basics:
An S-corporation is formed by first forming a C-corporation or LLC at the state level. This essentially means choosing an appropriate name for the business, filing Articles of Incorporation or Articles of Organization with the Secretary of State, identifying a registered agent for the business, and paying the filing fee.
If you are forming a corporation, you will also be required to:
- Elect directors;
- Issue stock to initial shareholders; and
- Create corporate bylaws
Once your business is formed at the state level, you will then need to file IRS Form 2553 with the IRS to confirm your election as an S-corporation.
In order to qualify for S-corporation status, your business must meet certain requirements laid out in I.R.C. § 1361, most notably:
- The corporation cannot have more than 100 shareholders;
- It can only have one class of stock;
- It can not have non-resident aliens as shareholders; and
- The shareholders can only be individuals, estates, certain types of exempt organizations, and certain types of trust
So, How Can an LLC Own Shared in an S-corporation?
I.R.C. § 1361 restricts those who can become shareholders in an S-corporation to individuals and certain types of exempt entities and trusts. This is to prevent foreign nationals from skirting US tax obligations by abusing the pass-through tax benefits that S-corporation status provides.
Typically then, if an LLC were to become a shareholder in an S-corporation, its S-corporation status would be canceled in the process. However, an exception to this rule exists in the case of a single-member LLC.
An LLC that has a single member is a disregarded entity for tax purposes. The IRS has ruled that, as a disregarded entity (meaning that there is no legal distinction between the LLC and the individual who owns it), a single-member LLC can own shares in an S-corporation, provided that:
- The single-member LLC does not elect to file as a corporation, since a corporation cannot own shares in an LLC, even if it only has one shareholder; and
- It meets all other S-corporation requirements.
For help to determine if your LLC can own shares in an S-corporation, call us to schedule a consultation with a knowledgeable and experienced Wyoming LLC attorney.