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The Best of Both Worlds (#4 in Sub-S Series)

You may recall seeing commercials on television in which one person eating chocolate bumps into another person eating peanut butter.  The complaint would be, “You got chocolate on my peanut butter!” and “You got peanut butter on my chocolate!”  I think we all know what that product is.  Those commercials were pointing out that their candy gave you the best of both worlds.

I think of getting the “best of both worlds” when I think about a single- or multiple-member LLC electing to be taxed as a Sub-S entity.  For the vast majority of businesses that generate ordinary or earned income (which can be subject to the highest rate of taxation), Sub-S tax status provides a welcome relief, while the liability protections of LLC law provide significant comfort relative to a business owner being able to limit their liability exposure.

Does this mean you can use an LLC taxed as a Sub-S to rob, cheat and be dishonorable?  Absolutely not, but it does give you the opportunity to better manage your tax risks and potential liability risks.

When a single-member LLC elects to be taxed as a Sub-S entity, it must do two important things.  First, it must make sure the operating agreement specifically allows for Sub-S tax treatment, which requires special language.  Second, it must file the appropriate form with the IRS electing to be taxed as a Sub-S corporation rather than being a disregarded entity.  Please see my previous post in this series for more information on that form and the timing of filing it.

Multiple-member LLCs can also elect to be taxed as Sub-S entities.  It is even more critical for these entities that the operating agreement be carefully drafted (hint: not a “free form” found on the internet!) and that the Sub-S election form be promptly filed with the IRS, as more than one person will have the tax consequences of this entity coming over onto their personal 1040 tax returns.

Another advantage to keep in mind is the advantage of your entity being an LLC rather than a true corporation.  You see, corporations have shares, and the owners are called shareholders and don’t have the same liability protection laws that LLCs do; thus, it is theoretically, repeat theoretically, possible that a judgment creditor of a corporation or individual could attempt to attach and take or foreclose on (depending upon which state you are in) the shares of stock in a Sub-S corporation that an individual may own. 

That type of theoretically-possible, hyper-aggressive collection tactic cannot be done with an LLC because LLCs have a protection relative to both the owners and the LLC itself.  Just a reminder, however, that not every state has the same degree of charging order protection for LLCs.             

Finally, I would caution you that you should not automatically file an LLC in Nevada or Wyoming just because you think they have better asset protection characteristics.  They really don’t.  In fact, they have some privacy and reporting issues that cause me concern compared to other states.

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