Although electing to be classified as an S corporation for tax purposes can bring certain benefits, including payroll tax savings, there are also significant drawbacks that LLCs should consider before making this choice. This summary highlights 10 key reasons why LLCs should not elect S corporation tax classification.
These reasons include potential termination of the S election due to language in the LLC operating agreement, gain recognition at the time of the election, taxable gain for new members contributing property, lack of flexibility in allocating income and deductions, inability to include entity-level indebtedness in the shareholder's tax basis, gain recognition for appreciated property distributions, no provision for achieving a step-up in tax basis, restrictions on shareholders and attracting investment funds, and tax issues in mergers or acquisitions.
Many LLC operating agreements contain language that can inadvertently result in the termination of the S election. If the operating agreement’s language is not revised beforehand, the LLC’s Subchapter S election may end up being involuntarily terminated.
An S election can result in gain recognition at the time of the election.
A new member that contributes property to an LLC that has made an S election may recognize taxable gain as though the property were sold to the LLC.
S corporations have no flexibility with respect to allocating items of income and deduction not in proportion to the shareholders’ ownership interests.
While a significant advantage of partnership taxation is the ability to include entity-level indebtedness in the partner’s tax basis of his or her interest in the partnership, a shareholder of an S corporation cannot include entity-level indebtedness in the shareholder’s tax basis of his or her stock.
While a partnership that distributes appreciated property to a partner generally does not recognize gain, an S corporation’s distributions of appreciated property to a shareholder can result in gain recognition.
Unlike the rules for partnerships, there is no provision in Subchapter S that permits the inside tax basis of the corporation’s assets to achieve a step-up in tax basis when a shareholder dies, when a person acquires the stock of a shareholder, or when there is a distribution of property or cash to a shareholder.
S corporations have other restrictions, such as a 100-shareholder limit and a rule that corporations and partnerships cannot be shareholders.
The one-class-of-stock rule can make it difficult for an S corporation to attract new rounds of investment funds.
Tax issues can arise for S corporations in the context of a merger or acquisition, although a possible workaround exists that relies on an F reorganization.
These factors should be carefully weighed against potential benefits before an LLC elects to become an S corporation.
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Michael Coronado is the Vice President of Pronto Income Tax. When he’s not serving clients, he geeks out on current events and planning his next travel adventure
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