Continuing a series on choice of entity for startups, I’m going to address the issue of whether your entity should be a LLC that elects to be treated as an S corporation for tax purposes. This is a two step process for federal tax requirements that can be achieved with the single action of timely filing an IRS Form 2553 election for the LLC. What is deemed to then happen is, firstly, the LLC is electing to be treated as a corporation (rather than a partnership for multi-member LLCs or a disregarded entity for single member LLCs). Secondly, the “corporation” for tax purposes is filing an election to be treated as an S corporation for federal tax purposes. Needless to say, your LLC needs to qualify under the many rules that govern qualification as an S corporation. These rules are beyond the scope of this post but a few are particularly relevant.
Is LLC Electing S Corp Status the “Best of all Worlds?”
In virtually every conversation I have on startups, someone asks if the LLC electing S corporation status is the “best of all worlds” form of entity. As with all posts on our blog, I’m going to get to the punchline rather than doing a treatise on all issues involved. In most cases, it is not and can have very disastrous consequences later. There are good reasons to use an S corporation for “simple” businesses that will likely never take on sophisticated outside capital. Most startups we see do not fall into this category. Most startups plan on taking on investment of some form from an outside investor other than pure friends and family (or they at least want to plan for the possibility). Almost all outside investors with any level of sophistication want rights and protections that would create a “second class of stock” for Subchapter S purposes and would disqualify the LLC as an S corporation. Liquidation preferences? Investor-only Dividends? Foreign Investors? Consider the S status blown. Even the casual angel investor is likely to want protections or rights that will disqualify the Subchapter S qualification. In order to maintain qualification as an “S corporation,” the LLC also cannot have institutional investors, such as other LLCs and venture capital funds, as owners. Again, for companies that may even possibly take on institutional investment at a later stage, the election can be a lurking tax problem.
The Tax Time Bomb–Phantom Income When You Least Need It
The reason the later termination can be a tax problem is because the termination results in a deemed sale of the company’s assets for federal tax purposes if the LLC elects the less restrictive partnership tax status (assuming its is eligible to do so at the time) or merges into another LLC in order to achieve this result. Without getting into the technical aspects, this often creates a recognized tax gain on assets that creates a present tax where no tax would have existed and where there is often no liquidity to distribute out the tax liability to the owners. This would not be the case if the LLC had simply accepted its default status as a partnership (or disregarded entity for a single member LLC) rather than an S corporation.