LLC Taxed as S Corp
If you have a limited liability company (LLC), you may have heard of the S Corporation status but may not completely understand what it means for your LLC.
How does it change your income and taxes? What are the pros and cons? Is it right for my LLC?
These are all questions we are going to aim to answer in today’s post because electing to tax your LLC with an S Corporation status may bring you some tax savings benefits.
The most common reason for an LLC to elect to be an S Corporation is for tax purposes.
In other words, to reduce self-employment taxes while keeping pass-through taxation.
Let’s learn more!
Benefits of an LLC
Many entrepreneurs and business owners choose an Limited Liability Company as their business entity for several reasons including:
- Limited liability – LLCs are considered separate entities from the business owner(s) and thus provide more liability protection than say a sole proprietor or partnership. Owners of an LLC have limited personal liability for the debts of the business and usually the liability amount is not more than the amount each owner invested in the business.
- Income tax purposes, mainly, Pass-through taxation – The income from the LLC passes straight to the owners, meaning that they are only taxed once as self employment income. They avoid corporate income tax altogether. Multi-member LLC’s are taxed as partnerships and are also pass-through entities.
- Less restrictions, paperwork, and formalities – LLCs generally have fewer record keeping requirements and can be flexible with their management structure.
How an LLC is Taxed
When electing an S Corporation for your LLC, it changes the way your LLC is taxed.
A standard LLC passes income through to its owners and they pay tax as self-employment income.
Self employment tax comes to about 15.3% broken down as follows:
- 12.4% to Social Security
- 2.9% to Medicare Tax
So your LLC income passes through to you as the owner and you pay 15.3% tax.
Pretty straightforward and simple to understand.
How an LLC with an S Corporation election is Taxed
When you are an LLC, your tax election is the same as someone that is self employed, meaning that you pay for the entire tax liability of 15.3%, as mentioned above.
If your LLC elects to be an S Corporation, you become an employee of the S Corporation and the tax liability is split between you and the company.
For example, instead of paying 15.3% you as the employee will pay 6.2% for Social Security and 1.45% for Medicare and the S Corporation will pay another 6.2% for Social Security and 1.45% for Medicare.
Self-employed people pay both halves of this tax liability.
Here are two other ways your tax liabilities change when you elect an S Corporation for your LLC:
- Income from a corporation is considered a dividend rather than earnings and this means the recipient(s) of the dividends don’t have to pay Social Security or Medicare taxes on that income.
- S Corporation owners can take a salary or let some of their business profits pass through as earnings while the others profits can be paid out as dividends, free of self-employment tax.
As you can see, electing an S Corporation for your LLC can have a few key tax savings advantages.
An S Corporation has some of the beenefits of an LLC as well as a C Corporation, but without the double taxation that a C Corporation is subject to.
Examples of LLC and S Corporation Tax Scenarios
Let’s say you are the sole member of an LLC that made $150,000 net income last year.
For federal income tax purposes, in a standard LLC business structure, all of the $150,000 is considered pass-through self-employment income and you would pay the full 15.3% in self-employment tax for a total tax liability of $22,950.
In an S Corporation scenario, you may choose to take $100,000 as pass through earnings and $50,000 as dividend income.
Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.
This means you would pay 15.3% on the $100,000 only for a total tax liability of $15,300. You will have had a tax savings of $7,650.
These tax benefits are really the main reason that LLCs elect to be taxed as an S Corporation.
S Corporation Requirements
In order to be approved for an S Corporation, there are some specific qualifications that need to be met:
- Must be a domestic corporation meaning that the corporation must be U.S. based with no more than 100 owners.
- Must have an allowable shareholder(s) which are individuals, certain trusts, and estates. They may not be partnerships, corporations, or non-resident alien shareholders.
- Cannot have more than 100 shareholders and only one class of stock.
- Certain business types such as financial institutions, insurance companies, and domestic international sales corporations are not eligible for an S corporation election.
Benefits of an S Corp (Pros)
If you meet all of the criteria above, then there are some benefits to an S Corporation election:
- Limited liability – Much like an LLC, an S corporation provides liability protection for the personal assets of its shareholders. So long as there isn’t a personal guarantee, a shareholder does not have personal liability for the business debts and liabilities of the corporation.
- Pass-through taxation – An S corporation does not pay federal taxes at the corporate level. Any business income or loss is “passed through” to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns to reduce income tax paid.
- Tax favorable characterization of income – Shareholders of an S corporation can draw “reasonable” salaries as employees of the business. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.
- Easy transfer of ownership – Interests in an S corporation can be freely transferred without triggering adverse tax consequences. The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
Limitations of an S Corporation (Cons)
Even though there are tax benefits to having an S Corporation election for your LLC, there are also some limitations that need to be mentioned:
- The restrictions and limitations on number of shareholders to only 100 and only one single class of shareholder makes it less attractive to investors.
- S Corporations have extra costs and administrative tasks and requirements such as record keeping and meetings requirements.
- The more dividends you take in an S Coporation election, the sooner you will cap out on your annual IRA and other retirement plan contribution plans. The more you take in dividends, the less you are allowed to put into a retirement plan which has other tax advantages to consider.
- S Corporations are more prone to being audited by the IRS because they want to make sure owners are not taking too high of dividends compared to a reasonable salary. If you get audited and the IRS determines that you didn’t take a reasonable salary, they could required you to reclassify some dividens and earnings and you might owe self-employment tax plus penalties and interest.
Single-Member LLC Taxed as S Corp
Single-member LLCs can elect to be an S Corporation and the same rules, benefits, and limitations apply as a multi-member LLC.
As the owner of a single-member LLC with an S Corp election, you are classified as an S corporation and will not longer be considered a self-employed individual.
Thus you will not be subject federal self-employment tax.
Instead, you are considered to be an employee and can also takes dividends as a result.
Becoming an S Corporation
When you formed your LLC, you most likely fell into one of two categories:
- A single-member LLC by default is treated as a sole-proprietor by the IRS
- A multi-member LLC by default is treated as a partnership status by the IRS.
In order to be treated as an S Corporation, the following forms must be completed:
- Form 8832 – This is the Entity Classification Election form provide by the IRS. This is completed so that your business will be taxed as a Corporation.
- Form 2553 – Once you complete the Form 8832, you then file Form 2553 which is hat officially gives the the S Corporation election and tax structure.
Does an S Corporation Get a 1099 Form?
One common question is whether or not an S Corp is required to get a 1099-MISC or 1099-NEC from their clients.
1099 forms are only used to report payments to sole proprietors and partnerships as well as standard LLC’s therefore an S Corporation is exempt.
However, there are a few specific types of payments made to corporations by your business, including payments to S Corporations, which would require you to report the payment on an S Corporation 1099:
- Box 6: Medical and health care payments
- Box 8: Substitute payments in lieu of dividends or tax-exempt interest
- Box 10: Gross proceeds paid to an attorney
As you can see, there are some wonderful tax benefits for having an S Corporation election for your LLC.
However, there are also some limitations to take into consideration as well as the increased IRS scrutiny.
Before making the election, we highly recommend speaking to a tax professional to determine which formation type is appropriate for your business.
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IRS.gov "S Corporations" Page 1 . April 27, 2021
IRS.gov "Form 2553" Page 1 . April 27, 2021
IRS.gov "Am I Required to File a Form 1099 or Other Information Return?" Page 1 . April 27, 2021