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My Company Is An S Corporation, Not An LLC.

My Company Is An S Corporation, Not An LLC.

The Important—yet Elusive—Distinction between the Legal Form and Tax Classification of Entities

As a corporate and securities attorney, it’s part of my everyday to discuss the current or desired entity structure of a given company with clients and other industry professionals.  During those conversations, it’s not uncommon for someone to confidently describe to me a company’s entity type as an “S Corporation, not an LLC.”  Although most of these individuals have some working understanding of the pros and cons of an S Corporation, many of them don’t understand that an S Corporation has everything to do with how a company is taxed and nothing to do with the legal type of the entity.  Similar confusion sometimes arises when someone refers to a company being “taxed as an LLC.”  This is problematic because a limited liability company (an “LLC”) can be taxed as a C Corporation, S Corporation, or Partnership, but there simply is no pure LLC taxation scheme.

So, let’s discuss the distinction between the legal entity type and tax classification.  On the one hand, every company is classified as some type of legal entity.  This concerns how the state where the company is formed will recognize the company for legal purposes.  Common examples include sole proprietorships, general partnerships, corporations, LLCs, limited partnerships (“LPs”), and limited liability partnerships (“LLPs”).  In general, the type of legal entity of a company will determine how it is governed (i.e., who manages the day-to-day operations, who makes important decisions for the company, who is authorized to sign contracts on behalf of the company) and how it is owned (i.e., shares of stock, membership interests, and partnership interests).  This has everything to do with the basic corporate structure of the company.  In addition, the type of legal entity will determine the extent of personal liability its owners may have for the debts and liabilities of the company.  For example, in a general partnership, each partner is personally liable, jointly and severally1)Joint and several liability is a legal concept that, in the context of a general partnership, generally means that each partner is personally liable for 100% of the debts and liabilities of the company, even if those debts and liabilities were actually brought about by another partner and even if those debts and liabilities were incurred by another partner without the express permission of the other partners., for all debts and liabilities of the company, while the liability of owners (referred to as, “members”) of an LLC is generally limited to their respective investments into the company.

Now, onto how a company is classified for tax purposes.  This concerns how the government will tax the income, gains, and losses of the company.  Generally speaking, a company is taxed by the federal government either as a Partnership, a C Corporation, an S Corporation, or as a Disregarded Entity2)The term Disregarded Entity refers to a tax concept whereby the existence of a given entity ignored for tax purposes and its owner is taxed directly for all of the income, gains, and losses of the company..  The specific differences in how a company is taxed under each of these classifications is a discussion that we’ll table for another day, but in general:

  • C Corporations are subject to double taxation (i.e., the company is taxed on its income and gains, and then the shareholders are taxed again when they receive dividends)
  • S Corporations and Partnerships are subject to pass-through taxation (i.e., income, gains, and losses of the company are passed-through to each owner based on their respective ownership interests or other special tax allocation arrangement, to be taxed only once at the owner level)
  • Disregarded Entities are subject to essentially the same pass-through tax treatment concept as S Corporations and Partnerships

Where things start getting a little confusing for many is taking one of the legal entity types discussed above and determining its tax classification.  The Internal Revenue Code provides default tax classifications for entities, based primarily on the number and type of its owners.  However, most companies with two or more owners have the option to elect to be taxed differently than the default setting—and even change the tax classification over the life of the company.  To make it easier to understand, here is a basic table illustrating this concept for each legal entity type discussed above:

 

Legal Entity Type Default Tax Classification Tax Classification Election Options
Sole Proprietorship3)A sole proprietorship can be comprised of only a single owner. Disregarded Entity None
General Partnership4)A general partnership almost always requires at least two partners. Partnership C Corporation
S Corporation5)Keep in mind that there are strict rules about the number and type of shareholders of an S Corporation.  Certain qualifications to make the election to be taxed as an S Corporation must be strictly adhered to or the tax consequences could be devastating.  In general, in order for a company to be eligible to be taxed as an S Corporation it must file the S Corporation election form and it must:

  • Be a domestic corporation
  • Only have shareholders who are individuals, certain trusts, and estates—no shareholder may be a partnership, corporation, non-resident alien, LLC, LLP, LP, or General Partnership
  • Have a maximum of 100 shareholders
  • Have only a single class of stock
LP Partnership C Corporation
S Corporation6)The IRS has ruled that, in order for a LP to make an S Corporation election the general and limited partnership interests must have identical rights to distribution and liquidation proceeds in order to satisfy the single-class-of-stock requirement.
LLP If only one partner = Disregarded Entity
If two or more partners = Partnership
C Corporation
S Corporation
Disregarded Entity7)In order to make the election to be taxed as a Disregarded Entity, the electing company can have only one owner.
LLC If only one member = Disregarded Entity
If two or more member = Partnership
C Corporation
S Corporation
Disregarded Entity
Corporation If only one shareholder = Disregarded Entity
If two or more shareholders = C Corporation
S Corporation

Now that you know the distinction between legal entity type and tax classification, you are better equipped to select what type of entity your company will be and how it will be taxed.  If you have any questions regarding the content of this article, please contact me at mmcgovern@mwrlegal.com or (512) 320-0601.

LEGAL DISCLAIMER: This article is not intended to be, nor may it be used as, legal advice or tax advice.  This article shall be used solely for general, non-directed informational purposes.  No attorney-client relationship has been formed by virtue of this article and Ressler + Wynne Ressler, PC has in no way agreed or consented to provide you with legal representation by virtue of this article.

 

Footnotes   [ + ]

1. Joint and several liability is a legal concept that, in the context of a general partnership, generally means that each partner is personally liable for 100% of the debts and liabilities of the company, even if those debts and liabilities were actually brought about by another partner and even if those debts and liabilities were incurred by another partner without the express permission of the other partners.
2. The term Disregarded Entity refers to a tax concept whereby the existence of a given entity ignored for tax purposes and its owner is taxed directly for all of the income, gains, and losses of the company.
3. A sole proprietorship can be comprised of only a single owner.
4. A general partnership almost always requires at least two partners.
5. Keep in mind that there are strict rules about the number and type of shareholders of an S Corporation.  Certain qualifications to make the election to be taxed as an S Corporation must be strictly adhered to or the tax consequences could be devastating.  In general, in order for a company to be eligible to be taxed as an S Corporation it must file the S Corporation election form and it must:

  • Be a domestic corporation
  • Only have shareholders who are individuals, certain trusts, and estates—no shareholder may be a partnership, corporation, non-resident alien, LLC, LLP, LP, or General Partnership
  • Have a maximum of 100 shareholders
  • Have only a single class of stock
6. The IRS has ruled that, in order for a LP to make an S Corporation election the general and limited partnership interests must have identical rights to distribution and liquidation proceeds in order to satisfy the single-class-of-stock requirement.
7. In order to make the election to be taxed as a Disregarded Entity, the electing company can have only one owner.