Are S Corporations obsolete?

Yes...99.999% of the time.

It is a little known fact that LLC’s are the most flexible limited liability entities in the U.S. They can can be structured to be taxed as a C corporation, S corporation, partnership, or sole proprietorship (an entity that is disregarded from its owner for tax purposes.)

PF Shield frequently encounters attorneys and CPA’s who prefer S corporations over LLC’s for many small business owners. They believe an S corporation provides superior tax savings. They argue that an LLC member must pay self-employment tax on their share of company profits (which is 15.3% of the first $89,900 of income), whereas the stock dividends received by S corporation shareholders are not subject to such a tax.

Therefore, they believe by making the small business owner an employee of the S corporation, with a salary that tends to be on the very low end of “reasonable”, all other compensation is received free of such taxes.

Although it is correct that tax savings can be gained in this manner, these professionals erroneously assume that only an S corporation can be taxed this way. What they do not realize is an LLC may elect to be taxed as an S corporation. It may do so by first electing corporate tax treatment by filing IRS form 8832, and then electing S corporation status by filing IRS form 2553. The fact the IRS allows LLC’s to elect S corporation tax treatment is verified by reviewing the form 2553 instructions.

If indeed your situation will benefit from S corporation tax status, then an LLC that is taxed as an S corporation is preferable over an S corporation 99.999% of the time.

Let us examine why an LLC is superior to an S corporation:

• An S corporation is more likely to have its “corporate veil pierced”.

   

  Because an S corporation has to follow corporate formalities whereas an LLC typically does not, failing to follow these formalities may trigger a piercing of the corporate veil during litigation. Furthermore, corporate structuring is inherently more prone to corporate veil piercing due to the domination or “alter-ego” theory. (An excellent overview regarding piercing of the corporate veil may be found in Garcia v. Coffman, 124 N.M. 12, 946 P.2d 216 (N.M.App. 06/17/1997)). Because an LLC can be single member, with a simpler one or two-tiered management structure (as opposed to a 3-tiered corporate management structure), in most cases the domination theory simply does not apply to an LLC.

   

• More often than not, when a corporation is sued, its corporate officers and/or directors are named as co-defendants in the lawsuit.

The litigator typically claims that the officers are guilty of negligence or gross negligence. Whether or not this is true is often irrelevant. As co-defendants, the directors and/or officers now face the nightmarish prospect of a trial and the discovery process. The litigator uses this fact as leverage to negotiate a much higher out-of-court settlement than he otherwise might have gotten. An LLC, however, may be structured so as to vest all management in another limited liability entity. Therefore, even if negligence or gross negligence at the management level is claimed, in a properly structured arrangement no natural person will be a party to the lawsuit unless the managing LLC’s limited liability veil is first pierced.

• Corporate stock is personal property that may be seized by judgment creditors of the stockholder.

If a creditor manages to seize enough voting stock in a corporation, he may then have the power to liquidate corporate assets to satisfy his claim against the original stockholder. LLC membership interests are, however, exempt from outright seizure. To learn more about this, read the section of this website entitled “Anonymous LLC'S/COPE'S.”

• Finally, because of the ability to form a simpler management structure, and little to no formalities to follow, an LLC is easier to operate.

Thus the LLC makes the S corporation virtually obsolete.

There is one very rare circumstance in which an S corporation would be preferable to an LLC. Because stock can be bought and sold more easily than LLC membership interests and the quick transfer of stock is essential, then an S corporation would be preferable.

However, this situation would occur with an S corporation in only the most rare circumstances, due to the fact that an S corporation is limited to 75 shareholders. Corporations that have stock that is frequently bought and sold are almost always C corporations because of this limitation. Therefore, an S corporation has been made obsolete by the LLC, 99.999% of the time.