Most privately held businesses in Arizona are limited liability companies. The LLC offers more flexibility compared to a corporation. There is a trend among owners of LLCs to elect to have their LLC taxed as an S-corporation rather than as a partnership or a pass-through entity (the defaults for multiple member and single member LLCs, respectively). While there are tax benefits to being taxed as S-corporation, specifically as it relates to self-employment tax, there are also several disadvantages to being taxed as an S-corporation. Here are a few of the disadvantages of an S-corporation:
- An entity taxed as an S-corporation cannot have more than 100 shareholders/owners
- With very limited exceptions, entities cannot be shareholders of an entity taxed as an S-corporation
- Distributions (not including wages) and allocation of profit and loss must be made pro rata based on ownership percentage
- An entity taxed as an S-corporation can have only one class of stock
These disadvantages primarily arise when clients approach me about (a) raising money from investors, (b) creating incentive compensation plans for key employees, or (c) providing for repayment of capital contributions prior to sharing profits. To clarify (c), if an entity is owned 50/50 by two individuals and one individual has paid $50,000 to fund the company and the other has paid $0, it is conceivable that the one that provided money would want a return of his or her money before sharing profits 50/50. An entity taxed as an S-corporation would not have the flexibility to make the appropriate distributions or allocation of profit and loss to allow that to happen.
If you or anyone you know has any questions about initial formation and structuring or would like your current structure reviewed, please feel free to call us for a free consultation. We work closely with our clients’ CPAs in making sure that the legal structure and tax structure are consistent and are aligned with our clients’ business expections.