Under IRS regulations, limited liability companies (LLCs) having two or more owners will be classified as a partnership for tax purposes and LLCs having only one member will be taxed as a disregarded entity. However, many owners of single- or multiple-member LLCs elect S corporation tax status for the LLC once formed. This election is achieved through a simple filing of Form 2553 with the IRS.
Oftentimes, the decision to elect S corporation tax status is motivated by employment tax treatment for S corporations. Generally, for LLCs taxed as partnerships, the owner is treated as a business owner and not as an employee of the LLC. The effect of this is that the entire amount of a member’s income which passes through from the LLC’s operations will be subject to self-employment tax. However, for LLCs electing to be taxed as S corporations, LLC owners who also perform services for the LLC will only be subject to employment taxes on the compensation paid to the LLC owner. As long as the compensation paid is “reasonable,” the S corporation status election means that the owners will not have to pay employment taxes on distributions made to LLC owners (i.e., profits paid other than those to owners as compensation for services).
Any LLC electing to be taxed as an S corporation must adhere to the specific eligibility rules applicable to S corporations. These eligibility rules include the following:
The requirement that the LLC may only have a single class of stock means that all members must have the same liquidation and distribution rights. The standard tax provisions in an operating agreement for LLCs taxed as a partnership would violate the single class of stock requirement. Most operating agreements for an LLC taxed as a partnership have provisions which would lead to distributions disproportionate to each member’s ownership interest, resulting in a second class of stock for purposes of the S corporation eligibility rules. For example, a common provision in an operating agreement for an LLC taxed as a partnership would be that liquidation distributions be made in accordance with positive capital account balances (before distributing any remainder according to ownership interest). This provision, or any other provision allowing for priorities on distributions, would violate the single class of stock requirement.
It is important for LLC owners electing S corporation tax status for the LLC to modify any existing operating agreements to remove the standard partnership tax provisions.
