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Can an S Corp own an LLC?

There may be some situations that may make it advantageous to have your S corp own an LLC. Learn whether this is possible and the pros and cons of having an LLC owned by S corp.

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One way to diversify a company’s portfolio of businesses is to form (or acquire) a subsidiary using the already-existing company. If, for example, you own a limited liability company (LLC), you may use it as a master in a series LLC. It would then own other subsidiaries in the series, thus helping you diversify without being the direct owner of those subsidiaries. The advantage of this type of business setup is that it creates a bigger corporate veil between you and your businesses, which helps to increase your personal liability protection.

But what if you are an S corporation owner and are thinking of forming (or acquiring) a limited liability company through your S corp? Can an S corp own an LLC? Find out the answer to this and other questions that may help you safely diversify your S corporation.

Key takeaways

  • While an S corp can own an LLC, an LLC cannot own an S corp.
  • One of the reasons for having an S corp own an LLC is to increase the corporate veil for business owners.
  • The biggest advantage of an S corporation is that its distributions to shareholders are tax-free.
  • On the other hand, S corps have strict ownership requirements. Selling shares to ineligible individuals may lead to the automatic loss of the S corporation status.

Can an S Corp own an LLC?

Yes, an S corp can own an LLC. Limited liability companies are usually owned by members, who can either be individuals or other business entities. Thus, an S corporation (which is a business entity) can be a member of an LLC.

The business structure of a limited liability company is such that the entity distributes ownership interest through shares. These shares can be sold and bought by an individual or business entity in accordance with the LLC’s operating agreement. And since they are separate legal entities from their owners, S corps are legally allowed to act as investors and buy into LLCs.

Can an LLC own an S corp?

Unfortunately, a limited liability company cannot own an S corporation. This is because S corps can only be owned by individuals – and in some cases certain trusts and estates – not LLCs or any other type of business entity. In fact, the Internal Revenue Service (IRS) specifies that a company may only elect the S corporation tax status if1:

  • It is registered as a domestic corporation in the U.S.
  • It has a maximum of 100 members.
  • All the members are permanent residents of the U.S, meaning that none can be nonresident aliens.
  • The corporation has only one class of stock, which means that it must not have its shares divided into common and preferred stocks.
  • None of the shareholders are members of other corporations or partnerships.

These requirements, along with other Subchapter S restrictions, mean that an LLC cannot be a shareholder or owner of an S corporation. This is sensible for tax purposes since S corporations are pass-through entities. They are allowed to pass income to their shareholders, who then file personal tax returns on business income.

If the S corporation shareholder is a disregarded entity like a single-member LLC (SMLLC), it may also pass the income to its owner. And since the IRS allows S corp owners to only pay themselves a reasonable salary (that’s taxable) and leave the rest of business income in the company as tax-free distributions (dividends), many business owners would use this loophole to skirt around paying taxes on business income realized by both the S corp and the LLC that owns it.

In other words, if a disregarded entity (like a single-member LLC) were an S corp owner, the IRS would miss collecting income taxes. That’s because S corp incomes are not taxed, but rather passed through to shareholders. SMLLCs incomes are also not taxed, so business profits would go completely untaxed. But if only individuals are allowed to own S corporations, all business profits can be passed to them, after which they would pay personal income taxes – including self-employment taxes – on those profits.

The bottom line is that while an S corp can own an LLC, the reverse is not possible – i.e., an LLC cannot own an S corp. Therefore, entrepreneurs who want to increase their corporate veil can consider forming an S corp first, and then using it to own an LLC.

Why would an S Corp own an LLC?

There are certain situations that may make it beneficial for an S corp to form or own an LLC. They include:

When you need to diversify. Whether you want to extend your product line or expand your brand into other markets, one way of doing it is through diversification. If you already own an S corp, you can use it to either form a new LLC or acquire an existing one. You may then use that LLC to introduce new products or push existing products into new markets.

To take advantage of the management flexibility of LLCs. Limited liability companies are generally more flexible than S corporations when it comes to distribution of ownership interests and profits. This is especially helpful when some members provide sweat equity in addition to capital equity. You may use the operating agreement of an LLC to proportion profits in a way that takes both types of contributions into account.

For liability protection. Finally, an S corp may want to create an LLC subsidiary whose business assets are protected from the liabilities of the parent company. This may be necessary if the S corp owns a valuable asset that creditors may come for in case of legal trouble. Rather than bundling it together with all other assets, the S corp can create a new LLC and transfer ownership of the asset (along with limited liability protection) to that new LLC.

S Corporation vs. LLC: Pros and cons

S corps and LLCs are similar in that both types of business entities are considered pass-through entities by the IRS. They also offer limited liability protection to their members. Beyond that, each type of business entity has its set of advantages and disadvantages to keep in mind.

LLC pros and cons

Pros of an LLC

  • Easy formation – the process of setting up a limited liability company is fairly simple and straightforward. There’s minimal paperwork and fees required. While the exact charges typically vary from state to state, any small business owner can register their own LLC. But if you are not sure how to go about it, consider consulting an experienced CPA or lawyer.
  • Liability protection – members of a limited liability company are not personally liable for business debts, liabilities and obligations. This means that as the owner of an LLC, your personal assets – including bank accounts, home, car and other investments – are safe from creditors who may sue the business and try to collect its assets. To ensure that you don’t lose these legal protections, it’s always a good idea to keep business affairs separate from personal affairs.
  • Flexibility in management – many state laws designate the management of a limited liability company to its members by default. However, the members – through an operating agreement – can transfer the day-to-day running of the business to professional managers. This is what creates the difference between member-managed LLCs and manager-managed LLCs. It also differentiates LLCs from other types of business entities, such as sole proprietorships which are typically managed by the owner and C corporations which are usually run by professional managers.
  • Pass-through tax advantages – unless its members elect otherwise, an LLC is a pass-through entity to the IRS. Meaning business profits go to members without being taxed by the federal government. Members are then required to file personal tax returns on their shares of earnings. This makes it easier to file tax returns since shareholders simply need to file form 1040 (Schedule E) to report their personal income tax. The pass-through taxation also helps LLCs avoid double taxation because their profits are only taxed at shareholder level, not at business level.
  • Unrestricted membership – LLC members are not restricted in terms of citizenship and numbers. Contrary to S corporations, which can only have a maximum of 100 members, all of whom must be U.S. citizens, LLCs can be owned by any number of members, some (or all) of whom may be nonresident aliens.

Cons of an LLC

  • Liability protection has limits – in certain situations, a judge can rule in favor of creditors who want to seize personal assets of an LLC owner due to business liabilities. This is known as “piercing the corporate veil” and it mostly happens when a business owner fails to properly separate business transactions from personal transactions.
  • Business discontinuity – many state laws (by default) require a limited liability company to be dissolved in case one member dies, goes bankrupt or leaves the company, unless surviving members vote to continue with the business. This is where an operating agreement and buy-sell agreement may help address the uncertainty of a leaving member, and thus prevent the dissolution of the LLC.

S Corporation pros and cons

Pros of an S corp

  • Limited liability – electing the S corporation status provides shareholders with personal liability protection. In case the business is unable to pay its debts, shareholders cannot be held personally liable for them. In other words, creditors are legally barred from seizing shareholders’ personal assets in an attempt to recover business debts.
  • Tax-free distributions – distributions earned by S corp shareholders are not charged payroll taxes. Therefore, shareholders need not pay unemployment, Social Security and Medicare taxes on whatever amount they earn as distributions. However, any shareholder who provides services to the S corp must be paid a reasonable salary, and they must file personal income tax on that salary.
  • Avoidance of double taxation – contrary to a C corp where earnings are taxed twice – first at business level and then at shareholder level – S corporations only pay taxes once (at shareholder level). They are not subject to federal corporate taxes. This tax treatment is what helps S corps to lower their tax liability and put more money in their owners’ accounts.
  • Additional tax benefits – the S corp tax classification automatically eliminates accumulated earnings tax, which is usually charged on C corporations. Similarly, when an S corp is sold, its shareholders often receive tax-free distributions, after which they may now pay tax on their personal earnings from the sale. This differs from the sale of a C corporation, where tax is paid by the business entity and also by shareholders when they receive the proceeds of the sale.
  • Business continuity – if you opt for the S corporation status during incorporation, you essentially choose to have a business that can exist in perpetuity. That’s because S corps are separate corporate entities that are not affected by the death, bankruptcy, incapacitation or exit of a member. This type of business entity may exist until it’s liquidated by members.

Cons of S corp

  • Cash retention can be hard – the IRS requires that any member who provides services to the S corp to be paid a reasonable salary. Other shareholders need distributions too so that they can file personal tax returns. This division of business earnings tends to make it hard for an S corp to retain cash for growth and expansion.
  • Strict ownership requirements – only U.S. citizens are allowed to own S corps. None of the shareholders should be a member of another LLC or partnership. Any infringement of these requirements automatically leads to the termination of the S corp. Keep in mind that a dissident shareholder can decide to sell their shares to an individual who is not allowed to be an S corp owner. This alone will trigger the termination of the company.

Frequently asked questions

Can an LLC own an S Corp?

No, an LLC cannot own an S corp. Subchapter S restricts the ownership of S corps to individuals, certain types of trusts and estates. Other business entities like LLCs cannot be shareholders of an S corp.

Can an S Corp be a member of an LLC?

Yes, an S corp can be a member of an LLC, meaning that the S corp will hold shares in the LLC. An LLC owned by S corp operates in the same way that an LLC owned by individuals does. In fact, the membership of an LLC can be a mixture of individuals and other business entities, including S corps.

References

IRS. “S Corporations.'' 18 Jun. 2022, https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

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