The Myth of the S-Corporation

June 12, 2017

I often hear potential clients say things like, “I want to form an S-corp,” or “should I form an LLC, S-corp, or C-corp?” This illustrates a very common misunderstanding about the nature of an S-corp. In today’s post, I hope to clear up this misunderstanding, once and for all.

The first thing to understand is this: LLCs and C-corps are things, and an S-corp is a choice. The best way to understand this is to go to any state’s website for forming businesses, and look at the different kinds of business entities available. For example, California allows you to form corporations, LLCs, limited partnerships, general partnerships, and limited liability partnerships. Under the category of corporations, you have for-profit corporations and non-profit corporations. Nowhere is forming an S-corp a possibility. The same is true for Delaware, too. When you are looking at the different kinds of business entities, an LLC is an entity, and a C-corp is an entity (although it will simply be called a “corporation”), but an S-corp is not an entity. So what is an S-corp?

An S-corp is a tax election that you make with the IRS. When you form a business at the state level, you have to choose a kind of entity – for example, an LLC or a corporation. Those two types of entities are taxed in different ways, however, and that’s where the S-corp tax election comes in. An LLC is a pass-through entity, meaning that the LLC’s net taxable income or loss is passed through to the owners in proportion to their ownership percentages, and the individuals report the income or loss on their personal tax returns. In the case of a corporation, the corporation itself must pay taxes on its taxable income, and its shareholders only incur tax liability with respect to corporate income that is distributed to them as a dividend. This is often referred to as “double taxation,” one of the most dreaded things since, well, peanuts in an elementary school.

If a corporation wants to be taxed more like an LLC, meaning it wants to be treated as a pass-through entity, it can make an S-corp election. There are some restrictions – the corporation can only have one class of stock, cannot have more than 100 shareholders, and in general, all shareholders have to be individual persons and US citizens or permanent residents. A corporation that has a stockholder who is a Chinese citizen and resident, therefore, would be disqualified from making an S-corp election. The fundamental thing to understand here is that you have two layers – the entity layer and the tax treatment layer. At the base is the entity layer – that’s the corporation. Laying on top of the entity layer is the tax treatment layer – that’s the S-corp election.

As further illustration of how this all works, an LLC can make an S-corp election too. You might ask, “since an LLC is already a pass-through entity, why on earth would it want to make an S-corp election?” That’s an excellent question. The reason is that when an LLC makes an S-corp election, it’s owners (the LLC members) can become employees of the LLC, and they will pay a reduced self-employment tax vs. merely taking money out of the LLC via distributions. So now you have the entity layer (the LLC), and on top of it is the tax treatment layer (the S-corp election).

One final note: the S-corp election is not written in stone. You can inadvertently blow your S-corp election, by taking on a disqualifying shareholder or exceeding the 100-shareholder limit, for example. You can also voluntarily give up the S-corp treatment, when it no longer is advantageous, or when it interferes with bigger goals, such as when a tech startup needs to take on venture capital investment.

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