Can an LLC Be Taxed as an S Corporation?

An S corporation is a pass-through entity for tax purposes. This means that if an LLC is taxed as an S corporation, the LLC doesn't pay corporate income tax. Instead, the LLC's profits pass through to the members, who report and pay tax on them when they file their personal income tax returns.

At first glance, this sounds similar to an LLC taxed as a sole proprietorship or partnership. But there is a key difference. If your LLC elects an S corporation tax structure, the LLC members are no longer self-employed and responsible for paying self-employment taxes—they can be employees of the LLC.

An LLC member employed by the LLC receives a salary. Income, Social Security, and Medicare (FICA) taxes are withheld from their paychecks, just as they would be with any employer. If the LLC makes a profit after it pays salaries and other expenses, those profits are reported on the members' personal tax returns as ordinary business income. Members pay income tax on ordinary business income, but they do not pay Medicare and Social Security taxes.

For a profitable LLC, the self-employment tax savings can be significant because members pay FICA taxes only on their salaries, not on the entire amount of the company's profit. An S corporation election can also enable owners to build more savings in retirement accounts.

But there's a catch: IRS tax rules require S corporation owners to pay themselves a reasonable salary. The IRS list of factors to consider in determining a reasonable salary includes training and experience, duties and responsibilities, time devoted to the business, contributions of non-shareholder employees, and what comparable businesses pay for similar services.

The IRS may give added scrutiny to the reasonableness of S corporation owner salaries. For this reason, it's a good idea to consult with a tax expert when establishing salaries for each LLC member.

Requirements to be an S corp for federal income tax purposes

Federal tax regulations limit the types of businesses eligible for S corporation taxation. To be an S corporation for federal tax purposes, your business must be a domestic (U.S.) corporation or LLC and must meet several other requirements:

• Have no more than 100 shareholders (or LLC members)
• Not have any shareholders (or LLC members) that are corporations, partnerships, or non-resident aliens
• Shareholders (or LLC members) can be individuals and certain trusts and estates
• Have only one class of stock

In addition, the business cannot be an ineligible corporation. Examples of ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations.

Limited liability company taxed as an S corp: Advantages and disadvantages

A major advantage of S corporation taxation is the ability to minimize self-employment taxes. Here's a simplified example to illustrate how this works: Suppose you have a single-member LLC taxed as a disregarded entity with $150,000 of profit. You'll pay self-employment taxes of 15.3% on this entire amount, in addition to income taxes.

Now suppose you elect S corporation taxation and pay yourself a reasonable salary of $90,000, leaving you with a business profit of $60,000. As an S corporation, you'll pay Medicare and Social Security taxes on your $90,000 salary, but not on the additional $60,000 business profit, saving you over $9,000.

Other advantages of S corporation taxation include:

• Owners can increase retirement savings by having the business contribute to employee retirement accounts
• Owners don't have to make estimated self-employment tax and income tax payments on their salaries

However, electing S corporation status adds some costs to your business. If your profits barely exceed your reasonable salary, being an S corporation may increase your administrative burdens without saving you significant amounts of money. Here are some of the costs and disadvantages of an S corporation compared to the default tax structure:

• If you don't already have other employees, you'll have to start running payroll
• S corporation tax returns are more complicated and typically need to be prepared by a tax professional
• Benefits such as health insurance provided to owners/employees who own more than 2% of the business are considered taxable income
• Your LLC and its operating agreement form need to be structured in a way that is consistent with S corp taxation

Changing your business tax status is a major decision that should only be made after discussing your specific situation with a legal and/or tax expert. Every business is different, and it's a mistake to assume you need to be an S corp just because other businesses are.

Limited liability company (LLC) taxed as a C corp

The final tax option for an LLC is to elect to be taxed as a C corporation. If your LLC is taxed as a C corporation, you can be a company employee, just as with an S corp. But there's a dramatic difference in the way business income is taxed.

C corporations file corporate income tax returns and pay corporate income tax on company profits. Shareholders (or members) also pay personal federal and state income taxes on dividends that are paid out to them. This double taxation of dividends at both the corporate and personal level is frequently cited as a drawback of C corporation taxation for small businesses. In contrast, S corp profits pass through to the owners for tax purposes and are taxed only on the owners' personal returns.

How to elect S corp status and file an income tax return

An LLC can elect S corporation taxation by filing Form 2553, Election by a Small Business Corporation. It must be signed by all the members and can be submitted by mail or fax. The form must be filed no more than two months and 15 days after the start of the tax year it is to take effect, or at any time during the previous tax year.

The Internal Revenue Service (IRS) will notify the LLC whether its election has been accepted and when it will take effect. The election remains in effect until it is terminated or revoked.

An LLC that has elected to be taxed as an S corporation must file a corporation income tax return on Form 1120S. The return is due on March 15 each year (or the next business day if March 15 falls on a Saturday, Sunday, or holiday). Form 1120S reports the income, gains, losses, deductions, credits, and other information for the LLC.

Because an S corporation is a pass-through entity, corporate taxes aren't paid when the return is filed. The information on form 1120S becomes the basis for K-1 schedules that the LLC must provide to each member. Schedule K-1 shows each member's share of the S corporation's income, deductions, and credits. Members use this information to report business income on their personal taxes.

Should my LLC be taxed as an S or C corp?

It's more common for a small business LLC to elect to be taxed as an S corp than it is to choose C corp taxes. Because of the double taxation of C corp distributions, many small business owners will pay less in taxes if they are taxed as an S corp.

However, if you plan to keep profits within the company—perhaps to fund a future expansion—rather than distributing them to the owners, it might be advantageous to be a C corp and pay taxes at the corporate tax rate. C corp taxation can also be preferable if you're seeking outside investment that could disqualify you from being taxed as an S corporation.

Business taxes can be complex, and your tax choices may have a big impact on your bottom line. Having your LLC taxed as a corporation is an important decision. It's best to consult regularly with a tax professional to make sure your LLC is being taxed in the way that's best for your current situation.

How do I know if my LLC is an S corp or a C corp?