So, you’ve decided on an LLC for your business. You may not know there’s a whole menu of tax options available to you, including being taxed as a sole proprietor, choosing C Corp taxation, and having your LLC taxed as an S Corp, which is a popular option among freelancers.
For anyone who’s heard about becoming an LLC taxed as an S Corp, questions abound. What paperwork do you have to file? Do you get to keep your LLC status? And how do taxes work? Here is the quick guide to the difference between an LLC and an S Corp, how they relate to one another, and why it may be possible to experience the best of both worlds for your business.
What is an LLC?
Forming a limited liability company (LLC) is one way to take your business to the next level and protect your personal assets from any damages that arise from your company. While an LLC doesn’t protect you against everything, it’s a reasonable step to take when you want to form a legal boundary between your business and personal assets. It also may be seen as more professional than simply owning a sole proprietorship.
Filing for an LLC business designation with your state requires filing articles of organization. If you’re currently a sole proprietor, becoming an LLC doesn’t impact how you’re taxed, unless you form an LLC electing S Corp taxation.
How LLCs are taxed
Since the IRS doesn’t recognize an LLC for tax purposes, it’s up to you to determine how you want to be taxed. An LLC has several options, depending on how your business works and which perks you want to enjoy.
By default, a single-member LLC is taxed as a sole proprietorship. For many business owners, this tax choice makes sense because some pass-through tax advantages can save you money over being taxed twice, like a corporation.
One downside of sole proprietorship taxation is that you have to pay self-employment taxes on your earnings. Self-employment tax is 15.3% of most of your taxable profits and goes toward your Social Security and Medicare. This can really add up!
You don’t have to keep your default tax classification, however, and can actually choose to be taxed as a corporation. The most popular path is an LLC electing S Corp status.
Benefits of an S Corp election for LLC
To be taxed as an S Corp, you’ll need to file Form 2553 (Election by a Small Business Corporation) with the IRS. This is in addition to the filing you did with your state to form the LLC. If your election is approved, the IRS will tax your LLC as an S Corp and expect you to follow the rules of S Corp taxation. Like sole proprietorships, S Corps are pass-through entities, which means all the profits are passed on to the owner’s personal tax return.
The most important thing you need to know about converting an LLC to S Corp taxation is that S Corp owners must pay themselves a “reasonable compensation” as employees of their business. An owner’s employee wages are subject to FICA payroll taxes, which are 15.3% (notice how that’s the same percentage as self-employment tax?). Your S Corp will pay half of these taxes (7.65%) and you, the owner-employee, will personally pay the other half (7.65%).
Given that you’re paying 15.3% in payroll taxes, why would you convert an LLC to S Corp taxation?
For a single-member LLC, S Corp election offers significant tax savings on the profits above reasonable compensation that’s passed on to the owner. This money is not subject to FICA payroll taxes like employee wages are and also not subject to self-employment tax, like sole proprietorship profits.
Plus, as a pass-through entity, S Corps aren’t subject to corporate taxes the way C Corps are, which means they avoid double-taxation. So, as an S Corp, you avoid double-taxation and avoid paying self-employment tax on your pass-through profits.
You’ll also get the same protections of a corporation or LLC. This can be a very lucrative option for companies that think they may generate significant profits in the future and hope to pay out earnings to owners.
Another bonus of having your LLC taxed as an S Corp is that you’re eligible for the 20% pass-through deduction. This Qualified Business Income Deduction (QBI) is a result of the 2017 Tax Cuts and Jobs Act (TCJA) and allows business owners to deduct up to 20% of their business profit from their income taxes. It’s phased out for the highest earners and isn’t available for some service businesses, such as law or financial services.
Between the self-employment tax savings and the QBI deduction, the S Corp election for LLCs is becoming more attractive to small-business owners who may not have considered this option in the past.
Important facts about S Corps
There are obviously some pretty great benefits to electing S Corp taxation. So, why doesn’t everyone pick this path? Like any business election, there are some limits to this structure.
- To change your LLC to S Corp taxation, you must file paperwork. It’s not granted automatically.
- You cannot have more than 100 shareholders.
- Each shareholder must be a person, not a business. Can an LLC own an S Corp? Nope, your S Corp must be owned by an individual.
- The shareholders must be U.S.-based; nonresident aliens cannot be owners.
- All issued stock must be of one class; preferred stock can’t be made available to a portion of shareholders.
If you can’t fulfill all of the above requirements, you may consider a C Corp status for taxes.
Changing from an LLC to S Corp
Many people think that when they choose S Corp taxation their LLC goes away. But actually, your LLC remains intact. The only change is how your LLC is taxed.
Here’s what you need to do to change your LLC’s tax treatment. Once your LLC is set up, you need to let the IRS know you want to be taxed as an S Corp. This is done through filing Form 2553.
When should you file your S Corp tax election? For new LLCs, you have 75 days after the date of formation to submit Form 2553. If your LLC has been around for more than 75 days, then you have until March 15 of the current year to file Form 2553. If approved, your S Corp tax election will be retroactive to the first day of the year.
If filling out IRS forms isn’t your thing, you can find professional help with the entire process, from forming your LLC to setting up the IRS designation. For some business owners, this is the best choice to make sure they get everything filled out correctly with the state they are doing business in and with the federal government.
Can an LLC be an S Corp?
Forming an LLC is much simpler (and often cheaper) than forming a corporation. That doesn’t mean you can’t have some of the perks of a corporation. By combining the legal structure of an LLC with the tax election of an S Corp, you can get the best of both. Each owner will be taxed according to their ownership percentage, which is then disbursed through a combination of employee wages and distributions.
You’ll also have much less paperwork and administrative work than if you formed a C Corp. The simplicity of an LLC with the tax advantages of an S Corp certainly sounds like a winning combo!
Paying reasonable wages
As we mentioned, one of the advantages of an LLC filing as S Corp is that you can pay profits out to owners as distributions. These distributions aren’t subject to employment taxes, like Social Security or unemployment insurance tax. Only the owner’s employee wages are subject to payroll taxes.
It would be tempting to only take distributions and skip out on payroll, but that’s a big no-no!. The IRS is wise to this scheme, and even published guidance for S Corp owners who hope to have all of their money paid out as distributions. It reminds them that when corporate officers and owners do actual work for the company, they should be paid reasonable wages for those services—wages that would be subject to payroll taxes.
Simply put, if you work for your S Corp, you should pay yourself reasonable wages first, and the rest can be paid out as distributions. Doing it the other way around (or not taking a reasonable wage at all) could land you in trouble with the IRS.
Of course, if you’re an owner who doesn’t actually work for the company, you don’t have to be paid a wage and won’t be paying federal employment taxes. Some owners aren’t active in the business and simply invest assets or cash, so they don’t have to be paid as employees at all.
Keep in mind, federal taxes are just one consideration for making sure you follow the rules. State taxation rules and filing requirements also apply. Should you be an LLC taxed as S Corp?
This may seem like a lot of information. How can you know if it’s the right path for you? Most people who form an LLC are doing it for liability protection, and you’ll still keep this perk if your LLC is filing as S Corp. But, you’ll have to ask yourself if your business earns enough to pay out income to owners beyond what they would make in wages, which is where the big money-saving opportunities lie.
If so, you can keep your LLC status and get the benefits of an S Corp without having to form a corporate entity. It’s also relatively simple to keep your LLC status and can be a cheaper and easier option than becoming a corporation.