I sometimes run across small business owners who have set up their business as a corporation, and I often ask why they chose a corporation rather than a limited liability company (or LLC). Sometimes the answer is that the business was incorporated before LLCs existed, or when LLCs were new and the lawyer who advised the owner was not familiar with LLCs or was not comfortable with using them, and that makes sense. Another relatively common answer is that the owner’s lawyer or, more often, accountant advised the owner that there were advantages to being taxed as a Subchapter S corporation rather than being taxed as an LLC, so the business was organized as a corporation rather than a limited liability company. That doesn’t make as much sense, at least not since 1997.
Although the history of LLCs can be traced back to earlier statutes in Germany and other European countries, there were no LLCs in the United States until 1977 when Wyoming passed the first LLC statute in the country. For several years after that, the use of LLCs was suppressed by uncertainty surrounding their status for income tax purposes.
The Internal Revenue Code did not (and still does not) include provisions specifically written for taxing LLCs. The question was whether they would be taxed as partnerships or as corporations, and the answer was not clear. In 1995, the IRS issued guidance identifying four specific attributes (continuity of life, centralized management, limited liability, and free transferability of interests) that the IRS viewed as characteristics of corporations. If the LLC had either three or four of those attributes, it would be taxed as a corporation. If it had no more than two, it would be taxed as a partnership. That method of categorizing LLCs for tax purposes quickly proved to be impractical, and in 1997, the IRS passed the “check-the-box” regulations that allows LLCs to elect how they will be taxed.
The default status for LLCs is to be taxed either as partnerships (if there is more than one owner) or as sole proprietorships (if there is only one owner). A limited liability company taxed as a sole proprietorship is referred to – for income tax purposes only – as a “disregarded entity” because the LLC itself does not have to file a tax return. Instead, the owner reports the LLCs profits and losses on the owner’s individual tax return. However, the LLC can elect to be taxed as a corporation under Subchapter C by filing IRS Form 8832 or as a corporation under Subchapter S by filing IRS Form 2553, the same form that corporations file to elect to be taxed under Subchapter S instead of Subchapter C.
That’s why the desire to be taxed under Subchapter S should never drive the decision to organize a business as a corporation instead of a limited liability company. If the business is incorporated, it can be taxed under Subchapter C or (if it meets certain restrictions) under Subchapter S. If a business is organized as a limited liability company, it can be taxed as a partnership or sole proprietorship (depending on the number of owners), or as a corporation under Subchapter C, or (if it meets the same restrictions that apply to corporations) as a corporation under Subchapter S.
For more on this subject, see our earlier post on The Difference Between Legal Form and Tax Status of a Business or Nonprofit.