LLCs paying taxes as an S Corporation: A legal blunder?

One common mistake made by business owners in either new or well-established businesses is that their company is set up as a limited liability company (LLC) with the State of Michigan and elects to be treated as an S corporation for Federal Income Tax purposes.  The result of this structure, or, for all intents and purposes, lack of structure, is that the entity is an LLC for state law purposes and a corporation in the eyes of the IRS.  We typically do not recommend this set up as there are pros and cons to each type of entity and it is important to maintain entity consistency on the Michigan and Federal Level.

In most situations, we do not favor LLCs for active, operating businesses. We do, however, recommend LLCs for rental and commercial real estate, and ownership and operation of capital equipment.

Why does State and Federal consistency matter?

The main purpose and benefit of setting up a business entity is to separate the liabilities of a business from the business owner’s personal assets.  In order for a business entity to properly protect the owner’s assets from liabilities of the business, the entity must be set up and operate as a valid business entity both on a State and Federal level.  The entity must also hold itself out to be a separate, valid, and lawful entity to customers and the public at large.  If a Michigan LLC is created but the company elects to be treated as an S Corporation with the IRS, an inherent disconnect between the operation, the tax filings, and the State corporate filings occurs.  If the business were to be sued, a plaintiff’s attorney may attempt to reach through the entity and assign liability to the business owner personally. This is particularly true for single-member LLCs, as historically they were not treated with the same liability protection as multi-member LLCs in some other states. Furthermore, the annual business activity of a single-member LLC is reported on the member’s personal tax return as a sole proprietorship. This is not a position that the business owner would ever want to be in when faced with a potential lawsuit.

In addition, there are certain tax-favored benefits afforded to the business owner in the operation, sale and merger of an S corporation that are not afforded to LLCs.  For example, if all of the shares of an S corporation are sold back to the company when a new owner buys in, the S corporation owner is afforded substantial tax benefits in the transaction.  These tax benefits do not exist for LLCs because the Federal Tax Code treats LLCs like partnerships. Rather than leaving the tax treatment of a sale or redemption of shares to be determined by the IRS on audit, it is far better to structure the entity as an S Corporation both on a State and Federal level from the inception, or at the very least, prior to the sale of the company. 

We also do not recommend that an LLC owning rental or commercial real estate or capital equipment elect to be taxed as an S corporation, as this election removes the tax benefits afforded to these types of LLCs under partnership taxation rules at the Federal level.

What do I do if my business is an LLC that elected to be treated as an S Corporation?

As indicated, this is a fairly common circumstance in the State of Michigan.  If a business has elected to be treated as an S corporation but is registered with the State of Michigan as an LLC, it signals to us that the entity is likely not set up properly with all of the required documents in place and therefore is not a valid LLC in Michigan.  Furthermore, even if it is a valid LLC, we highly recommend conversion to a corporation on the State level. 

If you have questions regarding the process for converting an LLC into an S corporation in the State of Michigan, please give us a call so that we can explain and assist with the process.