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What is the Difference Between an S Corporation and a Limited Liability Company (LLC)? Part 3

In our June 2013 Tax News edition, we discussed the differences in the formation of an LLC (state law) verses an S corporation (federal tax classification election), and in our July 2013 Tax News edition, we discussed taxation and significant state and federal tax differences. In this article, we will discuss if your client is considering making a change in ownership, or a change to their federal “check-the-box” tax classification election, and the affect these changes have to their tax year and tax payment due dates.

An LLC is a legal business entity formed under state law whose default classification is a partnership or a disregarded entity, depending on the number of members, but may file an election[1] to be classified as an S corporation provided the entity meets all other requirements to qualify as a small business corporation under Internal Revenue Code (IRC) Section 1361(b).[2] AnLLC treated as a partnership must follow the federal partner and partnerships rules, Subchapter K (IRC Sections 701 through 777) including the ownership change rule. This rule requires the partnership to be treated as terminated when there is a change of 50 percent or more of the total interests in a partnership within a 12-month period. This is commonly referred to as a Technical Termination. If there is a Technical Termination mid-year, the LLC will have to file two short-year tax returns and pay for two entities (annual tax and fee) because we treat each short-period return as a separate taxable year, and the due date for the filing and payment of taxes will be based on both the beginning and ending of each separate taxable year.
 
For example, if a multiple-member LLC is taxed as a partnership with two members, each owning 50 percent, and one member sells his interest to the other on June 30, the LLC terminates as a partnership effective June 30. The remaining member continues doing business as a disregarded single member LLC. The multiple-member LLC must file for the period from January 1 to June 30, and pay the annual tax and fee. The single member LLC must file for the period from July 1 to December 31, and pay the LLC annual tax and fee.

Remember an LLC’s annual tax is due on the 15th day of the 4th month after the beginning of the LLC’s year to avoid penalties. And both LLCs must estimate and pay the LLC fee by the 15th day of the 6th month after the beginning of the tax year. An estimated fee penalty may be assessed if it is underpaid. The tax return must be filed by the 15th day of the 4th month after the end of the taxable year.[3]

On the other hand, an S corporation that has a 50 percent or more change in ownership will not have this requirement. However, if the S corporation has a change in ownership that causes the corporation to cease to be a small business, for example having more than 100 shareholders, the S corporations will terminate. This is also commonly referred to as a Technical Termination. If there is a Technical Termination mid-year, the corporation will have to file two short-year tax returns. However, if there is a sales or exchange of 50 percent or more of the stock in the corporation during such year, or as otherwise provided a pro rata allocation must be made to determine which items are to be taken into account for each of the short taxable years. The minimum tax is required on all short period tax returns. However, since California law conforms to IRC Section 1362 and Treasury Regulation Section 1.1362-3(c)(5), both tax returns will be due on the same day.

[1]This S corporation election is made by filing the federal Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS). A taxpayer who has a valid federal S corporation election must file in California as an S corporation.

[2]For more details on the eligibility tests get IRS Instructions for Form 2553, Election by a Small Business Corporation.

[3]California does have a paperless extension that allows the tax return to be filed six months later.

 

 

Back to August 2013 Tax News