At Smith Jadin Johnson, a discussion point that often arises when meeting with new business clients is whether to make an S-Corporation election under the IRS rules. Often clients ask: My accountant said I should be an S-Corp, what do you think? This blog posts discusses the pros and cons of making an S-Corp election, particularly with a Minnesota limited liability company.
Business owners choose the limited liability company (LLC) as the preferred entity structure for a variety of reasons: LLCs are easy to form, they provide limited liability to the owner, they have flexible management structures, and they provide “pass through” taxation, meaning all earnings are taxed at the owner level; not the entity level.
So why make an S-Corp election with an LLC?
The answer rests with the payroll tax savings that only an S-Corp provides. LLCs that elect S-Corp status are allowed to hire the owner(s) as an employee(s). This saves the LLC money on payroll tax by dividing the profits of the entity between salary to the owner (subject to payroll tax) and distributions to the owner (not subject to payroll tax). By contrast, LLCs that do not elect S-Corp status must distribute all earnings to the owners, who in turn must pay payroll tax on all distributions. The payroll tax savings are the chief reasons clients make the S-Corp election with their LLC.
So why wouldn’t all LLCs elect S-Corp status?
What seems like a no-brainer for business owners still has some drawbacks. Clients need to keep in mind that there are two sets of laws that govern an LLC making an S-Corp election: the entity rules (the LLC statutes) and the tax rules (the IRS rules). These two sets of rules are not always harmonious. What is allowed under the LLC statutes may be prohibited under the IRS rules. Two issues need to be considered: shareholder structure, preferred shareholders, and allocation of profits and losses.
Per Minnesota LLC law, any person or entity may own an interest in an LLC. By contrast, with few exceptions, the IRS requires that S-Corps be owned only by “beating hearts” or human beings. Thus, while the LLC may allow another LLC or partnership or corporation to be a member, that “shareholder” would bust the S-Corp status. Accordingly, an LLC making an S-Corp election is limited as to whom may own the LLC.
LLCs are also free to offer different types of ownership as regards profits and management, meaning an LLC may offer some members only financial interests while other members receive financial and management/voting interests. IRS rules prohibit such “preferred” shareholder status with S-Corps.
Finally, LLCs may be flexible as regards how profits and losses are allocated to the member owners. Thus, a 60/40 ownership structure is not necessarily required to distribute profits and losses in a 60/40 split. To maintain S-Corp status, all profits and losses must be distributed to the shareholders on a dollar per share basis, meaning a 40% owner must receive 40% of the profits and losses.
While the payroll savings of an LLC making an S-Corp election are attractive in many situations, clients need to weight those savings against the restrictions that S-Corp elections have with respect to shareholders and the allocation of profits and losses.
At Smith Jadin Johnson, we advise numerous business owners on these business entity and tax election issues and would be happy to discuss the right plan for you and your business.