This guide will answer questions like can I convert LLC to S Corp advantages and disadvantages, can the S Corp be general partner in an LLC, can an S Corp be a partner in a partnership and can an S Corporation own an LLC. Key takeaways:

There are some disadvantages of filing as an S Corps like increased IRS scrutiny, more rules and restrictions.
Corporations and partnerships can't be shareholders but S Corps can own LLCs and be a general partner in partnerships.
Hiring a CPA to navigate S Corp elections is an easy way to avoid misclassifications.

Table of contents

The disadvantages of LLCs taxed as S Corps...Read more

Can the S Corp be a general partner in an LLC?...Read more

Can an S Corp be a partner in a partnership?...Read more

Can an S Corporation own an LLC?...Read more

Do S Corps have advantages over LLCs?...Read more

The disadvantages of LLCs taxed as S Corps

Let's talk about some of the downsides of having your LLC taxed as an S Corp. One big issue is the complexity. The IRS has a bunch of rules for S Corps, and if you slip up, you could lose that S Corp status. This is a major point in the whole S Corp vs LLC debate. If you’re asking, “Can I convert my LLC to S Corp and what are the advantages and disadvantages?” you should know that switching can add a lot of administrative work. S Corps need detailed records and regular meetings, which can be a hassle if you’re a small business owner handling everything yourself. Here are a few reasons you may not want to elect S Corp status.

Infographic entitled Disadvantages Of Filing As An S Corp listing cons for LLCs taxed as S Corps.

1. Choosing S corporation status can trigger taxes at the time of election

When an LLC classified as a partnership chooses S Corp status, it's treated as if it contributed its assets to the S Corp in exchange for stock. Right after that, for tax purposes, it's as if the LLC liquidated and distributed the S Corp stock to its members. If an LLC classified as a disregarded entity (single-member LLCs) makes the switch, the member is seen as contributing all assets and liabilities to the S Corp in exchange for stock. The IRS rules say you don't recognize gain or loss if you transfer property to a corporation solely for its stock, and you control the corporation right after the transfer. For LLCs, this usually means they should control the S Corp immediately after the deemed transfer, so no gain or loss is recognized. But if liabilities assumed by the S Corp exceed the tax basis of the transferred assets, the gain is recognized. It’s a key factor to consider when weighing the pros and cons of S Corp vs LLC. To avoid unexpected taxes, make sure you have a clear tax basis balance sheet before making the S Corp election. If the LLC's liabilities exceed its asset basis at the election date, you might face gain recognition and a tax bill.

2. S corporations might face taxes when giving appreciated property to shareholders

When an LLC taxed as an S Corp distributes appreciated property to a shareholder, it can lead to taxable gains. The IRS treats this distribution as if the property was sold at its fair market value, meaning the S Corp recognizes the gain, which is then passed through to the shareholders. This can result in a tax bill for shareholders. Additionally, if the S Corp used to be a C corporation or received assets from a C corporation, it might face extra taxes on built-in gains during a five-year period. So, when considering "Can I convert LLC to S Corp, advantages and disadvantages?" remember that while S Corps offer certain benefits, LLCs taxed as S Corps can face significant tax implications when distributing appreciated property.

3. If an LLC’s operating agreement isn’t updated, it could accidentally cancel the S Corp status

Many LLC operating agreements can unintentionally end the S election status. An LLC operating agreement is similar to a corporation's articles of incorporation and bylaws. For tax purposes, a domestic multi-member LLC defaults to a partnership, and a single-member LLC defaults to a disregarded entity. These operating agreements typically follow state laws and partnership tax rules, which can conflict with S corporation rules. One big issue is that an S Corp can only have one class of stock. Operating agreements written with partnership tax law in mind often include provisions like capital accounts, which can cause an S election to fail. If an LLC taxed as an S Corp has a defective agreement, its S election may be revoked, reverting the entity to a partnership or a C Corp. This is one disadvantage of S corporations. While defaulting to a partnership is generally better, it still poses issues like incorrect payroll and self-employment taxes. Fixing a defective S election requires a private ruling request to the IRS, which can be costly.

4. The one-class-of-stock rule can make attracting new investors difficult

An S corporation can't have different classes of owners, except for differing voting rights, due to the one-class-of-stock rule. In the S Corp vs LLC debate, this is a big deal breaker between the two business structures. Many modern LLCs use different membership classes to attract investors with various needs. For example, having Class A and Class B memberships with different priorities for distributions or returns would violate the one-class-of-stock rule if the LLC elected S status. Therefore, an S corporation isn't ideal for attracting new investment funds from individual investors who want more than common stock. This is a key difference between LLC and S Corp when considering business structure for investment purposes.

5. S Corps are limited to 100 shareholders and can’t have corporations or partnerships as shareholders

S Corps have some specific rules and restrictions compared to LLCs. For example, they can only have up to 100 shareholders. Shareholders have to be individuals, certain trusts or estates—corporations and partnerships can't be shareholders. Nonresident aliens also can't own shares in an S Corp. In contrast, LLCs offer more flexibility in these areas, which is another point of difference between S Corp vs LLC.

6. S Corps have to split income and deductions according to ownership shares

An S corporation has strict rules for sharing income and deductions. For S Corps, each shareholder’s share of income, loss and other items must match their stock ownership. This means that an S corporation can’t allocate these items differently from how shares are owned, which is a key disadvantage of S corporations. On the other hand, LLCs taxed as S Corps face similar restrictions. The lack of flexibility in how income and deductions are allocated can be a drawback. However, partnerships offer more leeway. They can allocate items in ways that don’t match ownership percentages, as long as they meet the "substantial economic effect" tests. To satisfy these tests, partnerships need to:

Keep partner capital accounts properly maintained.
Make liquidating distributions based on positive capital account balances.
Include either a deficit restoration obligation or a qualified income offset.

These rules ensure fair allocations and meaningful economic impacts, highlighting the flexibility of LLCs taxed as partnerships compared to the more rigid S Corp structure.

Can the S Corp be a general partner in an LLC?

An S Corp can be a general partner in an LLC. This means it can help run the LLC and share in its profits and losses. The S Corp benefits from the S Corp partnership owner benefits agreement, getting tax perks while being involved in the LLC's day-to-day activities. However, there are important things to remember. The S Corp needs to follow the LLC’s rules and partnership guidelines. Also, the money the LLC makes will pass through to the S Corp shareholders, who will need to include it on their personal tax returns.

Can an S Corp be a partner in a partnership?

An S Corp can be a partner in a partnership. This means the S Corp can take part in the partnership's activities and share in its profits and losses. The S Corp benefits from this setup while keeping its own tax advantages. However, the income and losses from the partnership will show up on the S Corp tax return. This information then passes through to the shareholders of the S Corp, who report it on their personal tax returns. Just make sure the S Corp follows the partnership’s rules and keeps up with IRS regulations to avoid any tax problems.

Can an S Corporation own an LLC?

An S Corporation can own an LLC. The main difference between LLC and S Corp is their tax treatment and structure. When an S Corp owns an LLC, the LLC is usually treated as a disregarded entity or a partnership for tax purposes, depending on how many members it has. This means that if an S Corp owns a single-member LLC, the LLC’s income and losses flow through to the S Corp tax return. For a multi-member LLC owned by an S Corp, the LLC’s income and losses are also reported on the S Corp tax return. However, the S Corp has to follow certain rules. The LLC should be aligned with the S Corp ownership rules and be managed according to the LLC's operating agreement.

Do S Corps have advantages over LLCs?

When comparing S Corps to LLCs, there are clear S Corp advantages over LLC structures. One big advantage is in how they're taxed. S Corps allow owners to take part of their income as salary and the rest as distributions, which can reduce self-employment taxes and save money. Another S Corp advantage over LLC is raising capital. S Corps can issue stock, making it easier to attract investors. They also often have more credibility with banks, which can help them get loans. FlyFin’s expert CPAs can help business owners understand the difference between LLC and an S Corp and the disadvantages of LLCs taxed as S Corps along with providing unlimited tax support on the app.

LLC tax loopholes

LLCs can use tax loopholes to lower taxable income and their tax bill. FlyFin offer expert CPA support to handle business taxes on the app.

Are There Any Disadvantages To File As An S Corp?