Taxing an LLC as an S Corporation?

An LLC can elect to be taxed as an S corporation, and for some LLCs this choice can result in significant tax savings. For others, doing may introduce unnecessary complexity without substantial benefits. This article discusses when to do so may make sense.

LLC Tax Classifications

A Limited Liability Company (LLC) has flexibility in choosing its tax classification. By default, an LLC is taxed as a disregarded entity (a sole proprietorship) if it has one member, or a partnership if it has multiple members. Alternatively, an LLC can elect to be taxed as an S corporation (by filing IRS Form 2553) – or a C corporation (by filing IRS Form 8832).

Tax Benefits and Obligations of an S Corporation

When an LLC is taxed as an S corporation, the business itself doesn’t pay corporate income tax. Instead, the profits pass through to the members, who report and pay taxes on their personal income tax returns. This pass-through taxation model is similar to that of sole proprietorships and partnerships but with a key distinction: S corporation members can be treated as employees.

Members of an S corporation receive salaries and are subject to standard income, Social Security, and Medicare taxes on these wages. However, and this is key, any remaining profits distributed to members are not subject to self-employment taxes, potentially leading to significant tax savings.

Example of Self-Employment Tax Savings

Consider a single-member LLC that has $250,000 in annual profit. If taxed as a disregarded entity (default status), the owner would pay self-employment taxes of 15.3% on this entire amount, in addition to income taxes. This results in approximately $38,250 in self-employment taxes.

If the LLC elects S corporation status and the owner takes a reasonable salary of $100,000, the self-employment tax would only apply to the salary portion, which amounts to $15,300. The remaining $150,000 of profit is not subject to self-employment tax, saving the owner approximately $22,950 in self-employment taxes.

Key Considerations for S Corporation Election

Reasonable Salary: The IRS mandates that S corporation owners pay themselves a reasonable salary. This salary should reflect a figure within the range of what is customary for the owner’s role within his or her industry for a comparably sized business.

The IRS may closely examine S corporation owner salaries to ensure compliance with reasonable compensation requirements. It is prudent to consult one’s tax advisor before setting the owner’s salary.

Eligibility Criteria for S Corporation Status: To qualify for S corporation status, an LLC must:

• Be a domestic entity.
• Have no more than 100 shareholders (members).
• Ensure all shareholders are individuals, certain trusts, or estates (not corporations or partnerships)
• Offer only one class of equity security – a membership interest in an LLC.

Advantages and Disadvantages of S Corporation Taxation

Advantages: The advantages of an LLC electing S corporation taxation include:

• Potentially lower self-employment taxes.
• Possible increased retirement savings through business contributions to retirement accounts.
• Simplified tax payments through withhold taxes on salaries, eliminating the need for estimated self-employment tax payments

This last advantage – simplified tax payments, should not be underestimated.  When cash flow gets tight, an LLC taxed under default status – particularly a single member LLC, it is easy enough for the owner to skip the quarterly estimated income tax deposit by telling him or herself that they can catch up on the deposits next quarter.  Such delay, however, can snowball quarter to quarter until the owner has a material underpaid tax obligation incurring late penalties.  In contrast, if the LLC is taxed as an S corporation, the owner’s salary – generally administered by a third party, is subject to regular withholding taxes. And, while the owner may still have an obligation to pay quarterly estimated tax on profits – the net profits are reduced by the amount the owner caused the LLC to be paid as his or her reasonable salary, and the taxes on that salary are paid as withholding taxes.

Disadvantages: Disadvantages of LLC being taxed as an S corporation include:

• Additional administrative tasks, such as payroll management.
• More complex tax returns requiring professional preparation.
• Taxable income for owner benefits like health insurance for those owning more than 2% of the business.

When to File Form 2553 and Effectiveness of the S Election

To change an LLC’s tax classification to an S corporation the LLC files Form 2553 with the IRS. This form must be filed no more than two months and 15 days after the beginning of the tax year in which the election is to take effect. For a newly formed LLC, its first tax year begins the day its articles or organization (or equivalent) are filed with its state of organization. For example, an LLC organized on January 7 begins its first tax year on January 7. The 2-month period ends March 6 and 15 days after that is March 21. To timely elect S corporation treatment beginning with the LLC’s first tax year, it must file Form 2553 during the period that begins January 7 and ends March 21.

Alternatively, an LLC previously taxed under default status as a disregarded entity (sole proprietorship) or partnership (or, in some cases, as a C corporation), can file at any point during its current tax year to be taxed as a S corporation beginning the first day of its next tax year.  It may also file Form 2553 during the current it wants the change to be effective if it does so within two months and 15 days during the current year that corresponds with the first day of its last tax year.  For example, if the prior tax year began January 1, the LLC would need to file between January 1 and March 15 of the current year for the S corporation election to be effective for that tax year. If it misses this window, the S corporation status won’t be effective until the next tax year.

If an LLC meets the eligibility requirements for S corporation tax treatment, electing S corporation tax status can result in significant tax savings for certain LLCs.  Any such election should be made in consultation with the LLC’s tax advisor.