From a tax perspective, S corporations (S corp.) and limited liability companies (LLCs) share an important similarity: both are what's known as "pass-through" entities. This means that, rather than being taxed as entities in their own right, the income each earns is passed through to be taxed in the hands of each of the S corporation shareholders or LLC members.
However, despite this similarity, there is a difference in whether an ownership relationship between an LLC and S corp. is permitted—that is, whether or not one can own the other, whether it's S corp. ownership of an LLC or LLC ownership of an S corp.
The S Corp.–LLC Relationship: S Corporation Ownership Rules
The S corporation is a federal tax designation, so the requirements governing ownership of an S corp. are set by the IRS.
These requirements are fairly strict and, for the purposes of discussing whether or not an LLC can own an S corporation, it boils down to this: an S corp. may be owned by individuals (either U.S. citizens or permanent residents, but not nonresidents) and certain trusts and estates, but not by business entities such as C corporations and partnerships.
LLC Ownership of an S Corporation
If C corporations and partnerships aren't permitted to own an interest in an S corporation, then what about LLCs? Because the IRS's strict S corp. requirements complicate the ownership relationship between an S corp. and an LLC, whether or not an LLC can hold an ownership interest in an S corporation is not as clear-cut.
LLCs with more than one member are usually considered partnerships and taxed as such; the exception is when the LLC elects to be taxed as a corporation. Because neither a partnership nor a corporation can own an interest in an S corporation, a multi-member LLC that is viewed from a tax perspective as a partnership or a corporation would also be prohibited from owning an S corporation.
What about single-member LLCs, then? From a tax perspective, income is passed through the single-member LLC to its sole member. Whether or not the single-member LLC is permitted to hold an ownership interest in an S corporation therefore depends on the specific circumstances:
- Where the single-member LLC has made an election to be taxed as a corporation, or where the sole member of the single-member LLC is a corporation or partnership, it cannot hold an ownership interest in an S corporation.
- Where, however, the single-member LLC is owned by an individual, and that individual is eligible to own an S corporation—that is, the individual is a U.S. citizen or permanent resident, and not a nonresident—then, in such a case, the LLC can hold an ownership interest in an S corporation.
When Can an S Corp. Own an LLC?
Are things as complicated the other way around? Can an S corp. be a member of an LLC? There are fewer restrictions on who may hold ownership interests in an LLC.
Ownership requirements will vary from state to state, but generally speaking, and subject to any existing business-related state restrictions, an S corporation will be eligible to be a member of an LLC.
The main issue in this case isn't whether or not the S corporation can own an LLC, but rather the tax treatment that will result from S corp. ownership of an LLC:
- Because the LLC is a pass-through entity for tax purposes, if the S corp. is the sole owner of the LLC—making the LLC a single-member LLC—and no election has been made by the LLC to be taxed as a corporation, then the LLC becomes a disregarded entity and its income flows through to be taxed in the hands of the S corporation.
- If the S corp. is one of two or more owners of the LLC—making the LLC a multi-member LLC—then the LLC is treated as a partnership, and the income it generates is taxed as partnership income in the hands of its owners.
- And, finally, if the LLC has elected to be taxed as a corporation, it will file its own separate tax return.
How Does an S Corp. Benefit from Being a Member of an LLC?
Generally speaking, from a tax perspective, there's probably no significant advantage to an S corporation owning interest in an LLC, as both are treated as pass-through entities.
However, there may be certain business circumstances where the flexibility of managing a business through an LLC may be attractive for the S corporation.
For example, in an LLC, unlike a corporation—and subject to the terms of the operating agreement—members are free to negotiate ownership percentages independent of the amount of their investment.