Can a C-Corp Use an LLC to Bypass S-Corp Ownership Regulations?

Many wonder whether a C-Corporation can maneuver around the restrictions placed on S-Corporations by utilizing an LLC. This article explores the regulations, potential workarounds, and the legal consequences of such actions.

The Regulation Landscape: S-Corp Ownership Restrictions

S-Corporations are designed for tax purposes to pass through income to shareholders, with specific ownership limitations. According to IRS regulations, only individuals (excluding nonresident aliens), certain trusts, and estates can be shareholders in an S-Corporation. C-Corporations, a different entity type, are explicitly prohibited from owning shares in an S-Corporation.

LLC as a Pass-Through Entity

While an LLC can be treated as a pass-through entity for tax purposes, its restructuring in terms of ownership does not circumvent the regulations. If an LLC is owned by a C-Corporation, the LLC itself is either a disregarded entity or a corporation for tax purposes—depending on its structure. This means that in the end, the C-Corporation is still the ultimate owner, and the LLC cannot hold shares in an S-Corporation.

Substance Over Form

Regulatory authorities typically apply the principle of "substance over form, " meaning that they will scrutinize the underlying intentions and actions rather than just the surface structure. Attempting to bypass the ownership rules would likely not hold up under scrutiny, leading to significant legal and tax consequences.

Legal and Tax Consequences

Pushing the boundaries of the regulations by attempting to circumvent them could result in severe penalties. This includes the potential loss of S-Corp status, significant IRS penalties, and other legal ramifications. It is essential to adhere to the established rules to avoid such complications.

Key Takeaways and Recommendations

A C-Corporation cannot create an LLC to bypass the S-Corp ownership rules, as such an arrangement would not withstand scrutiny from authorities. The LLC cannot hold shares in an S-Corp even if it is treated as a pass-through entity, as it would ultimately be under the control of the C-Corporation. Structuring investments or ownership involving S-Corps and C-Corps requires consulting with a tax professional or legal advisor to ensure compliance.

Understanding S-Corp Shareholder Qualifications

Further clarification on who can hold shares in an S-Corporation is provided:

U.S. citizens or residents (not nonresident aliens). Natural persons, excluding corporations and partnerships. Certain trusts and estates are eligible, along with specific tax-exempt corporations, including 501(c)(3) organizations. Single-member LLCs are also allowed. An S-Corporation can own shares in another S-Corporation if it owns 100% of the stock and an election is made to treat the subsidiary as a disregarded entity.

Code and Regulations

The regulations surrounding S-Corp ownership are rooted in the Internal Revenue Code, specifically Section 1361. The Code clearly states that an S-Corporation cannot have a shareholder who is not an individual. Exceptions exist for certain trusts and an individual’s estate, but C-Corporations are explicitly excluded.

Key Citations

IRS S-Corp Information 26 U.S. Code § 1361 - S corporation defined United States Code Title 26, Chapter 1, Subchapter O, Section 1361

Conclusion: To ensure compliance and avoid potential legal and financial risks, it is crucial to understand and adhere to the regulations governing S-Corp ownership and to seek professional advice when structuring ownership in complex business entities.