If you think your business would benefit from the combined features of using an LLC to own and operate your small business and then having it be taxed like an S corporation, the possibility exists.
If you decide to form an LLC to own and operate your small business, you have a couple of choices for how you want your LLC to be taxed. For federal income tax purposes, there is no such thing as being taxed as an LLC. Instead, an LLC can be taxed like a sole proprietorship, a partnership, a C corporation or — if it qualifies — an S corporation.
Although being taxed like an S corporation is probably chosen the least often by small business owners, it is an option. For some LLCs and their owners, this can actually provide a tax savings, particularly if the LLC operates an active trade or business and the payroll taxes on the owner or owners is high.
Reasons for forming an LLC: Limited liability and flexibility
So you are ready to start a small business. You have a wonderful vision for a unique, new service or special product. Your business plan is a work of art. You are ready to let go of the safety and security of your cubicle at the office and blaze a new trail of entrepreneurship. Congratulations!
Now, as you start, run, and grow your new business, how do you intend to structure it so that it becomes an efficiently operating and thriving enterprise? The most popular organizational formation for small businesses is the limited liability company (LLC).
An LLC is a business structure authorized by state statutes. It is a structure designed to provide the limited liability features of a corporation along with the tax efficiencies and operational flexibility of a sole proprietorship or a general partnership. As a pass-through entity (unless it chooses tax treatment as a ”regular” or C corporation), all of an LLC's profits and losses pass through the LLC to its owner(s), known as member(s). As with a proprietorship or partnership, each individual member reports the profits and losses on his or her federal tax return. This avoids the double taxation to which a regular corporation and its owners are subjected.
However, the LLC still provides a limit on the personal liability of its member(s) in much the same way a corporation does. Typically, a member's personal liability is limited to his or her investment in the LLC. This feature distinguishes the LLC from a sole proprietorship or general partnership, in which each owner is subject to liability for all of the debts of the business.
The following summarizes the most significant features of the LLC:
- Limited liability for owners
- Pass-through of income to owners, avoiding double taxation (unless C corporation tax treatment is elected)
- Ease of operation: fewer formal meetings and record-keeping requirements
- Fewer profit-sharing restrictions: earnings distributed as members see fit; not based on percentage of capital contributions—although there are restrictions if S corporation taxation is chosen
- Entire net earnings of an LLC pass through to owners in the form of self-employment income subject to 15.3 percent SECA tax (self-employment tax for Social Security and Medicare)
How is an LLC taxed?
Default tax classification of an LLC
For tax purposes, by default, an LLC with one member (owner) is disregarded as an entity. Or, in other words, a single-member LLC is treated as a sole proprietorship. By default, LLCs with more than one member are treated as partnerships and taxed under Subchapter K of the Internal Revenue Code.
LLC taxed as a corporation
An LLC can elect to be treated as an association taxable as a corporation (C corporation) by filing Form 8832, Entity Classification Election. If so, the LLC will be taxed under Subchapter C of the Code.
LLC taxed as an S corporation
First, an LLC would need to elect to be taxed as a corporation by filing Form 8832, Entity Classification Election. After that, an LLC can then file a Form 2553, Election by a Small Business Corporation, to elect tax treatment as an S corporation.
How does taxation as an S corporation differ from taxation as a sole proprietorship or partnership?
Sole proprietorships, partnerships, and S corporations are all pass-through entities for tax purposes. But they are not taxed the same. A main difference is that Subchapter S of the Code imposes a number of restrictions on the entities that can select S corporation taxation.
General S corp restrictions and requirements:
- the company must be formed in the United States
- there cannot be more than 100 owners
- only individual, U.S. residents can own interests
- there can only be one class of owners — no preferred shareholders or members
Subchapter K, which governs entities taxed as partnerships, contains no such restrictions. These restrictions take away some of the flexibility of an LLC and can make it harder to attract outside financing.
Advantages of S corp election
There are, however, some advantages of S corporation tax treatment. The main reason to prefer S corporation tax treatment over partnership treatment has to do with employment taxes. Under the Code, an owner of a business taxed as a partnership — who is employed by the business — is considered an owner. An owner of an entity taxed as an S corporation who works for the business is considered an employee.
With an entity taxed as an S corporation, only the wages paid to its owner/employees are earned income subject to FICA tax for Social Security and Medicare. Other net earnings that pass through to the owners are considered dividend income. This means those payments are not subject to SECA tax — provided the owner materially participates in the business — and they are not considered passive income.
Thus, an LLC taxed as an S corporation can do some tax planning that cannot be accomplished in an LLC taxed as a partnership or disregarded as an entity.
Another possible advantage comes from the Tax Cuts and Jobs Act. That tax reform bill gives pass-through entities a 20% “qualified business income" deduction.
However, businesses with taxable income above a certain amount don’t qualify unless they pay employee wages. Therefore, under some circumstances, S corporation taxation can help an LLC qualify for the deduction. Of course, this is a simplified description of a complex matter and the advice of tax experts should be sought out.
Combining the benefits of the LLC entity and S corporation tax treatment
If you think you can benefit from the combined features of using an LLC to own and operate your small business and then having it be taxed like an S corporation, the possibility exists to establish your business as an LLC, but then make the election to have it treated as an S corporation by the IRS for tax purposes. You'll have to make the special election with the IRS using Form 2553. Here are some things to remember:
- From a legal standpoint, your enterprise will be an LLC rather than a corporation. Therefore, you will have the benefit of ease of administration — fewer formal meetings and record-keeping requirements.
- From a tax perspective, your enterprise will be treated as an S corporation. You'll still have the pass-through of income, avoiding double taxation — same as if your LLC was treated as a proprietorship or partnership.
- The business entity can pay wages and salaries to you or to other owners. This amount will be subject to FICA tax and other withholding requirements. But then, it can distribute the remaining net earnings to you and the other owners as passive dividend income, not subject to SECA tax.
- Being treated as an S corporation may provide opportunities for tax planning to minimize the overall tax liability for your business and you.
Obviously, you need to carefully consider the pros and cons of different forms of business organizations and the different ways these organizations can be taxed. Seeking professional advice from a CPA or tax attorney is always a wise practice when making choices like this that can affect your business for many years to come.
How does an LLC with an S corp election file taxes?
An LLC that has elected to be taxed as an S corporation should file Form 1120-S, U.S. Income Tax Return for an S Corporation with the IRS. Each member (owner) would report their pro-rata share of corporate income, credits, and deductions on Schedule K-1 (Form 1120-S).
Conclusion
Setting up an LLC and then electing treatment as an S corporation may just give you the best of both worlds — the ease of administration of the LLC and the tax planning opportunities of the S corporation.
More questions about LLCs?
When it comes to LLCs, there is a lot for small business owners to think about — from liability and taxes to LLC business management and more. To help you decide which business structure is best, try BizFilings’ Incorporation Wizard Tool.