Can an LLC Own An S Corporation? Myths, Caselaw, and IRS Guidance Explained

The intersection of limited liability companies (LLCs) and S corporations (S corps) is a frequent source of confusion for business owners and advisors. One of the most misunderstood questions is whether a single-member LLC (SMLLC) can own an S corporation. Many believe this is not allowed, but the answer is more nuanced and depends on federal tax classification and the structure of ownership. This article provides a detailed, SEO-optimized review of the rules, IRS guidance, and relevant caselaw, clarifying the legal landscape for single-member LLCs with respect to S corporation ownership.

S Corporation Ownership Rules: Statutory Foundation

The Internal Revenue Code (IRC) is explicit about who can be an S corporation shareholder. Under IRC §1361(b)(1), eligible shareholders include:

• Individuals (U.S. citizens or residents)

• Certain trusts (grantor trusts, qualified subchapter S trusts, electing small business trusts)

• Estates

• Certain tax-exempt organizations

Corporations, partnerships, and most LLCs are generally ineligible to own S corporation membership interests or stock. If an ineligible entity becomes a shareholder, the S corporation's status is terminated, and it is taxed as a C corporation.

However, the IRS has clarified that a single-member LLC, if treated as a disregarded entity for federal tax purposes, is not considered a separate entity from its owner. This technicality forms the basis for allowing a single-member LLC to own an S corporation membership interest or stock, provided the sole member is an eligible S corporation shareholder.

IRS Guidance: The Role of Disregarded Entity Status

The IRS has addressed this issue in several Private Letter Rulings (PLRs), holding that a single-member LLC can be an S corporation shareholder if the sole member is an eligible person (such as an individual U.S. citizen or resident). Because the SMLLC is disregarded for federal tax purposes, the IRS looks through the LLC and treats the individual owner as the direct shareholder.

For example, in one PLR, an individual transferred S corporation stock to his solely-owned SMLLC. The IRS ruled that this did not terminate the corporation’s S status because the SMLLC was disregarded and its owner was eligible. The tax information for the SMLLC is reported on the owner’s personal return, mirroring the treatment if the individual held the interest directly.

It is important to note that this treatment is strictly limited to single-member LLCs. If another person becomes a member, the LLC becomes a partnership for tax purposes and is no longer eligible to own S corporation stock, which would terminate the S election.

Notable Caselaw: Judicial Interpretation

While most guidance comes from IRS rulings and the statute itself, some caselaw provides insight into how courts interpret these rules.

Kates, et al. v. Commissioner, T.C. Memo. 1968-264

In Kates, the Tax Court addressed a situation where a partnership arranged for the purchase of all of a corporation’s stock and then elected S status. The court found that the stock, although issued in the name of one partner, was beneficially owned by the partnership. Because partnerships are ineligible S corporation shareholders, the S election was invalidated.

This case is instructive because it demonstrates the importance of beneficial ownership. If an LLC with more than one member (thus taxed as a partnership) owns S corporation stock, the S election is lost.

Private Letter Rulings and IRS Position

Although PLRs are not binding precedent, they reflect the IRS’s position that a single-member LLC, as a disregarded entity, does not violate S corporation shareholder eligibility rules. The IRS has consistently ruled that so long as the sole member is an eligible person, S corporation status is preserved.

The Single-Member Requirement

The eligibility of a single-member LLC to own S corporation stock or membership interests is contingent on the LLC remaining a disregarded entity. If another member is added, the LLC becomes a partnership for tax purposes and immediately becomes an ineligible shareholder. This would cause the S corporation to lose its status and be taxed as a C corporation from the date of the change.

Operating Agreement and Single Class of Stock

S corporations must have only one class of stock (or membership interest), meaning all distributions and allocations must be pro rata according to ownership percentages. Many LLC operating agreements contain provisions (such as preferred returns or liquidation preferences) that violate this rule. Before an LLC elects S corporation status or acquires S corporation interests, its operating agreement must be carefully reviewed and amended to ensure compliance.

Tax Basis and Liability Issues

When an LLC elects S corporation status or acquires S corporation stock, it is crucial to have a clear tax basis balance sheet. If the LLC’s liabilities exceed the tax basis of its assets at the time of the election or acquisition, gain may be recognized under IRC § 351(b). This can result in unexpected tax consequences for the owner.

Charging Order Protection

One reason to hold S corporation stock through a single-member LLC is to take advantage of the charging order protection available in many states. This can limit a creditor’s ability to access the owner’s interest in the S corporation. However, as noted in In re Modanlo, this protection may be weaker for single-member LLCs, especially in bankruptcy contexts.

Statutory and Regulatory Citations

• IRC § 1361(b)(1): Defines eligible S corporation shareholders.

• IRC § 1361(c)(2): Lists exceptions and further clarifies eligible shareholder types.

• IRC § 351: Governs transfers of property to a corporation in exchange for stock.

• IRS Private Letter Rulings: Multiple PLRs confirm the eligibility of SMLLCs as S corporation shareholders if the sole member is eligible.

• IRS guidance on single-member LLCs: Confirms disregarded entity status for federal tax purposes.

Common Misconceptions

A frequent misunderstanding is that “LLCs cannot own S corporations.” In reality, the rule is that entities taxed as partnerships or corporations cannot be S corporation shareholders. A single-member LLC, if disregarded for tax purposes and owned by an individual or other eligible person, is not treated as a separate entity and thus does not violate the rule.

Another confusion arises from terminology. S corporations are corporations for federal tax purposes, but state law may allow LLCs to elect S corporation status. In this context, “stock” refers to ownership interests in the S corporation, whether structured as shares or membership interests, depending on state law and entity type.

Business Planning and Best Practices

Before transferring S corporation interests to a single-member LLC, business owners should:

• Confirm that the LLC is a disregarded entity for federal tax purposes.

• Ensure the sole member is an eligible S corporation shareholder.

• Review and, if necessary, amend the LLC’s operating agreement to comply with the single class of stock requirement.

• Monitor ownership to prevent inadvertent conversion to a partnership.

• Consult with a qualified tax advisor or attorney to avoid pitfalls related to basis, liability, and creditor protection.

  
  

A single-member LLC can own an S corporation membership interest or stock if the sole member is an eligible shareholder under IRC § 1361. This is because the IRS disregards the LLC for federal tax purposes and treats the individual owner as the direct shareholder. However, if the LLC acquires additional members, it becomes a partnership and is no longer eligible, causing the S corporation to lose its status. Both statutory law and IRS guidance support this position, and relevant caselaw underscores the importance of beneficial ownership and entity classification.

Business owners considering this structure should proceed with caution, ensure ongoing compliance, and seek professional advice to avoid costly mistakes.

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