If you’re a small business owner, choosing the right business structure can seem like a puzzle. One piece of that puzzle might be an LLC taxed as an S Corporation. Let’s break that down.
An LLC, or Limited Liability Company, and an S Corp, or Small Business Corporation, have distinctive advantages. LLCs give you personal protection from the company’s debts and obligations, while S Corps can provide money-saving tax strategies.
But guess what? You don’t have to pick one over the other.
Your LLC can get the same tax benefits as an S Corp through a process called entity classification election.
Based on our experience as financial counselors, we’re going to break down complex topics like “reasonable salary,” “taxable income,” and “tax advantages” that characterize LLCs and S Corporations. Let’s dive in and explore this more.
- An LLC taxed as an S corporation provides owners with unique tax advantages such as the ability to avoid self-employment state taxes on a portion of their income and deduct business losses and healthcare premiums.
- While being an S corporation brings potential benefits like lower tax liabilities and attractiveness to investors, it also comes with limitations including strict shareholder restrictions and more rigorously enforced compliance requirements.
- Choosing to elect S Corp taxation is a decision dependent on the LLC’s specific circumstances, including income levels, business size, industry, and long-term growth goals.
What Is an S Corporation?
An S Corporation, or S Corp, is a type of corporation in the U.S. that is designated by the IRS for a special tax status. This status allows the corporation to avoid double taxation – once at the corporate level and again at the individual level.
Rather than the company itself, it is the shareholders who report the income, deductions, losses, and credits of the S corporation. They do this by incorporating these amounts into their personal tax returns.
It is beneficial for small businesses and startups who wish to take advantage of the legality of a corporation but with the tax benefits of a partnership or sole proprietorship.
LLC vs. S Corp: How Are They Taxed?
An LLC taxed as a sole proprietorship or partnership (more than one member), for tax purposes, pays self-employment tax on its entire net business income. Roughly speaking, the self-employment tax rate is 15.3%, covering Social Security and Medicare.
According to the IRS, this could translate to an impactful chunk of your earnings.
On the flip side, an S corporation, a particular type of business entity, may offer some tax advantages. S corps pay their employees (including the owners) a reasonable salary on which payroll taxes for Social Security and Medicare are due.
However, all additional corporate income distributed to the S Corporation’s owners is considered a distribution, which can sidestep self-employment taxes, potentially saving thousands.
However, it’s not all roses. S corporation tax treatment isn’t suitable for all. The business must maintain all records, minutes, and issue stock. A single-member LLC or a disregarded entity, as opposed to an LLC electing to be taxed as an S corporation, will not have these requirements, simplifying operations.
Plus, tax cuts introduced under the Jobs Act lowered the Corporation tax rate, potentially offsetting some advantages of the S Corp over the C Corporation.
As always, engaging the services of a tax attorney to manage daily business operations and file LLC taxes, is recommended.
How to Elect an S Corporation Status for Your LLC
If you have decided to change your LLC’s status, here are the 5 essential steps you will need to follow:
- Step 1 – Verify Eligibility: To opt for S corporation status, your LLC must first meet specific requirements set forth by the Internal Revenue Services. The LLC must be a domestic entity, have only one class of stock, and have 100 or fewer owners who are individuals, estates, or certain trusts. Importantly, all LLC owners must agree to the S corporation tax status.
- Step 2: Obtain an EIN: An Employer Identification Number is essential before making any tax classification changes. If you don’t already have one, you can obtain an EIN online from the IRS website at no cost.
- Step 3: Prepare IRS Form 2553: On this form, indicate that you wish to be treated as an S corporation for tax purposes. Be precise in filling out every field on the form, and be sure that all LLC members sign it.
- Step 4: Submit Form 2553: Lastly, mail the Form 2553 to the IRS. You should receive confirmation of your S corporation status within 60 days. If you don’t, follow up with the IRS.
- Step 5: Notify the State and LLC Members: Once you have received the confirmation that your LLC is now treated as an S corporation, let the authorities in your state know about this change. Also, all the members should be notified as soon as possible.
Benefits of Choosing an S Corp Tax Status
For many small business owners, electing to have their LLC taxed as an S corporation could be a game-changer. Let’s delve into the details of why this approach can be beneficial.
- Pass-Through Taxation
In our experience, small business owners often find the pass-through taxation of S corps appealing. S Corps pass income, losses, deductions, and credits through to their shareholders for federal income tax purposes.
Essentially, an S corp as a pass-through entity is only taxed at the shareholder level, thus avoiding double taxation commonly associated with C corporation taxation.
- Limited Liability Protection
Personal liability protection is another strong point in favor of LLCs taxed as S corporations. This protection means personal assets are not at risk if someone sues the business or it incurs debt.
We’ve noticed that this structure provides peace of mind, letting owners focus more on growth without worrying about personal financial risk.
- Ownership Flexibility
This type of corporation avoids paying social security and medicare taxes on dividend income, thus, only the wages are subject to these taxes.
Over the years, we’ve guided numerous businesses in saving notable amounts on Medicare taxes thanks to this key S corporation feature.
One inside tip from our team’s extensive experience is to make use of the Foreign Earned Income Exclusion if your S corporation has overseas operations. This can additionally reduce your overall tax liability.
- Attractive to Investors
We’ve noticed that a key advantage of having an LLC taxed as an S corporation is its appeal to investors. As per this study, angel investors are more likely to invest in S corporations over traditional LLCs.
Many shareholders value the S Corp’s tax treatment, which can lead to significant tax savings. This status positions your business as a legitimate, financially savvy entity, which can increase your credibility among potential investors.
- Deductible Business Losses
Another meaningful perk of the S corp is the opportunity to deduct business losses. If an LLC declares itself as an S Corp, the company’s losses can flow through to owners’ personal income taxes, which can lower the overall taxable income.
This advantage, typically not available in C corporations, can particularly benefit startups or companies struggling in their initial years.
- Healthcare Benefits
In our hands-on exploration, one quite significant advantage that S corporation employees, including owner-employees, enjoy is the ability to deduct the cost of health insurance premiums.
Census data reveals that, in 2022, around 7.9% of people did not have health insurance at any point during the year.
For small businesses, offering health insurance may enhance the company’s profile, help attract top talent, and provide considerable tax benefits. As an owner-employee of an S Corp, health insurance premiums paid by the company are tax-deductible.
- Lower Self-Employment Taxes
The prospect of lower self-employment taxes tends to be one of the most appealing aspects of S corp tax treatment. Sole proprietorships, on the other hand, have to face the daunting task of paying taxes on net earnings from self-employment.
If we compare, sole proprietors pay self-employment tax on a significant portion of their income. In contrast, S Corps only pay Social Security and Medicare tax on the employee wages or salaries the S Corp pays to its owners.
The remainder of the company’s income is distributed as dividends, which are not subject to self-employment tax.
Case Study: From our in-depth research, for instance, an owner who lowers their self-employment income from $100,000 to $60,000 could save around $6,000 when they pay self-employment taxes. Here’s how:
- If an owner has self-employment income of $100,000, they would pay the full Social Security tax (12.4%) on the portion of their revenue up to the Social Security tax cap (in 2023, up to $160,200), and they would also pay the Medicare tax (2.9%) on the entire $100,000.
- If that owner reduces their self-employment income to $60,000, they would pay the full Social Security tax (12.4%) on the portion of their revenue up to the Social Security tax cap (still up to $160,200), but the Medicare (2.9%) would only apply to the reduced income of $60,000.
- By reducing their revenue from self-employment from $100,000 to $60,000, the owner effectively lowers the amount of income subject to the Medicare tax, which is 2.9% of the revenue. This reduction in taxable revenue results in lower self-employment duty.
However, remember that the IRS requires that a “reasonable salary” be paid before profits are distributed.
Drawbacks of Choosing an S Corp Taxation
Despite attractive benefits, electing S Corp taxation comes with various challenges that might deter certain LLC owners. Let’s now explore some of these potential drawbacks.
- Restrictions on Shareholders
S Corporations impose restrictions on who can be a shareholder. As per the Internal Revenue Code, these entities can’t have more than 100 shareholders. Additionally, shareholders are limited to individuals, certain trusts, and estates.
Notably, non-resident aliens aren’t eligible shareholders, presenting a drawback to LLCs interested in international shareholders.
Remember, violating these rules could revoke your S Corp status, returning you to a regular corporation with a significantly increased tax liability.
- Ownership Restrictions
While a multi-owner LLC can have members with different types of membership interests (differing in terms of voting rights, distribution rights, etc.), an S corporation cannot.
S Corporations are constricted to one class of shares, which may deter investors who prefer preferred shares. Plus, this restriction on ownership flexibility can be disadvantageous in raising operating capital or in exit strategies.
- Limited Growth Potential
In our hands-on exploration, compared to a C corporation, an S corporation often faces growth limitations. A typical C corp can issue various classes of shares, allowing it to attract different types of shareholders and amass significant capital.
However, as we have already mentioned, a business entity treated as an S corporation is confined to one class of stock only, which can stifle fundraising opportunities.
- Passive Income Limitations
S corporations must be mindful of tax limitations tied to passive revenue, including from investments like real estate.
Our expert analysis indicates that if more than 25% of an S corp’s gross income is considered passive income for three consecutive years, the S corp can lose its status.
This can affect businesses depending on investments as their main revenue source. Hence, limited liability companies operating in the investment sector might want to reconsider electing S Corp taxation.
- Strict Compliance Requirements
Adopting an S Corp status means more rules and paperwork. According to a United States Government Accountability Office report, 68% of S corps were misclassified due to non-compliance with these requirements.
You need to maintain rigorous records, conduct annual meetings, and follow strict corporate rules. Also, wages paid to S corp owners must be “reasonable”, which the IRS checks for regularly.
If you’re a small business owner who values flexibility and fewer formal meetings, an S corp might not be the perfect fit.
Should You Opt for an S Corp?
Deciding whether to opt for an S Corp tax status heavily depends on your specific circumstances. Remember, while S Corps can potentially save you money when you need to pay taxes for self-employment, it’s not suitable for every business.
As a whole team, we’ve learned over the years that if your LLC income is high, and you’re looking to save on Medicare and Social Security taxes, an S corporation choice might be beneficial.
Before you leap, however, remember the increased scrutiny from the IRS. Particularly regarding the way you pay wages to any S corporation employee and maintain business records, the monitoring might seem daunting.
Overall, our advice is to consider your business size, structure, and tax situation carefully. Measure these against the benefits and responsibilities of an S Corp tax status.