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.