Succeeding in Your Business: What to know when an LLC makes a Subchapter S election

“I have operated a service business for the past few years as a limited liability company (LLC) and have been quite successful.
“My accountant is recommending that I change my LLC so it’s taxed like a Subchapter S corporation. I understand she is trying to save me money on taxes by doing this, but I’m confused by what I’m reading on the Internet. Do I then have to operate as a corporation, with a board of directors, shares of stock and all that?”

First of all, let me say that if you are relying on the Internet for legal and tax advice, you are certain to end up confused.

Your LLC is being taxed as a partnership (or, if you are the sole owner, as a sole proprietorship). The LLC does not pay taxes, and everything flows through to your personal bottom line: You pay taxes based on your personal tax rate and file Schedule C on your personal Form 1040 each year.

By electing to have your LLC taxed as if it were a Subchapter S corporation, you could elect to take money out of the company as either compensation for your services or a distribution of corporate profits. Doing this reduces the amount of Social Security (FICA) and Medicare taxes you pay — a significant tax break if your LLC is generating more than $100,000 per year in income.

You don’t have to form an actual corporation to get the benefit of Subchapter S tax treatment. Your LLC can elect to be taxed as a corporation (by filing IRS Form 8832) and then take the “sub S” election (by filing IRS Form 2553) within the first 75 days of your company’s tax year (between Jan. 1 and March 15 for a calendar-year company).

When your LLC elects Subchapter S tax treatment this way, it does not become a corporation for state law purposes. You will not need a board of directors or shares of stock and you will not have to follow any other corporate formalities (such as drafting corporate resolutions each time you want to do something that is outside of the ordinary course of business). The rights and obligations of your LLC’s owners and managers continue to be governed by your state’s LLC statute and your LLC operating agreement.

What changes is the way your LLC is taxed, and your LLC will be subject to the many tax rules that apply to Subchapter S corporations. So, for example:

• You will file Form 1120-S, rather than Schedule C, which is due on April 15 each year (the same as your Form 1040).

• You can’t have more than one class of LLC membership interest. If an investor wants preferred stock in your company, he or she will be out of luck.

• You can’t have more than 100 LLC owners (called “members”). This would rule out any attempt to raise capital via crowdfunding, as even a moderately successful offering will leave you with more than 100 investors.

• All of the LLC owners must be either U.S. citizens or green card holders. You cannot incentivize your key distributor in France or your app developer in Poland by giving them shares in your company the way you can with an LLC.

If you are running a local service business, complying with these rules will be a piece of cake. But there are a couple of hoops you will need to jump through.

First, your LLC operating agreement will need to be revised. The tax provisions in that agreement (those relating to how income and loss are allocated to the owners, and how distributions of cash and property are handled) were designed for a partnership and will need to be changed to reflect those more commonly found in the shareholder agreement of a Subchapter S corporation.  Your accountant will probably not be comfortable doing this. You will need a lawyer’s help here.

Second, your operating agreement needs a provision voiding any transfer of ownership interests that would terminate the LLC’s Sub S election (for example, an inadvertent transfer by will to a non-U.S. citizen).

Third, you will need to be careful when issuing stock to employees, contractors and others to make sure you aren’t creating a prohibited second class of stock. According to Thomas Riggs, a CPA and tax lawyer with the firm of PKF O’Connor Davies LLP in New York City, it’s OK to give nonvoting shares to employees as long as the absence of voting rights is the only difference between their shares and yours.

Lastly, by taking a Sub S election, your LLC will no longer be able to issue tax-advantaged profits interests to employees and contractors enabling them to participate in the company’s future growth. You will have to issue them options the same way a corporation would, according to Riggs.

The bottom line: Make sure the tax benefits you will get from the Sub S election are worth the cost, in time and dollars, of complying with the Sub S rules.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.” 

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