What is an LLC?
Mark Pierce, Esq.
A limited liability company, or LLC, is a legal business entity that’s formed in order to own and operate a business. LLCs file state taxes under a certain set of regulations. LLCs are popular 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 which have only one owner, there is no limit on how many members you can have in the LLC.
What is an S-Corp?
S Corporations, or S-Corps, are corporations that elect to pass corporate income, losses, deductions, and credits through to the shareholders for federal tax purposes. S-Corp shareholders are taxed at their individual income tax rates as they report the flow-through of income and losses on their personal tax returns. This allows S-corps to avoid double taxation on the corporate income.
To qualify for S-Corp status, the corporation must meet certain requirements. One of these 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 cannot be a shareholder without cancelling 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 LCC 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.
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. 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.