Limited Liability Companies (LLCs) may greatly benefit by electing S-Corp taxation because members may still retain pass-through tax benefits while taking advantage of certain deductions or tax breaks.
For example, if a single owner of an LLC receives annual compensation of $100,000, he or she will pay income tax plus a 15.3% payroll or self employment tax on the whole $100,000. If the same LLC was taxed as an S Corporation, the LLC owner could receive a "reasonable salary" of $60,000, and take out the remaining $40,000 as investment income, for which no payroll tax is due. This would result in a savings of $6,120.00 in payroll taxes (15.3% of $40,000) for the year. While there are some additional administrative costs associated with an S Corporation tax election, they are usually outweighed by the tax savings when the owner-employees are each receiving $60,000 or more per year in compensation.
In December 1996, the IRS issued the final "check the box" regulations, which allowed an LLC to elect whether to be taxed as a corporation or partnership. In addition to potential payroll tax savings, choosing to be taxed as one entity over the other may have benefits under state and federal law, depending on the type of business and the jurisdiction. The deadline for filing the necessary IRS Form is "2 months and 15 days from the first day of the taxable year," which for most businesses is March 15. Please see Instructions for filing here.
While electing S-Corp taxation may benefit your business, it carries certain restrictions. First, under partnership taxation, profits and losses can be allocated with some flexibility, but all S-Corp profit and loss distributions must be made pro-rata by shares. Second, S-Corps are limited to 100 shareholders, so LLCs with more than 100 members would be subject to "double" entity and individual taxation if they elected corporate taxation. Third, shareholders of S-Corps must be individual US citizens or certain trusts, while members of LLCs may be corporations, other LLCs, and alien members. Fourth, some businesses, such as financial institutions and insurance companies, cannot be S-Corps. An LLC that does not meet these restrictions may lose substantial tax benefits by electing corporate taxation.
There are other pitfalls as well. Your LLC Operating Agreement should be amended to reflect the S-Corp tax election. Most Operating Agreements are worded for partnership taxation, and conflicts between the governing document and actual tax election can lead to unwanted tax surprises and cause the entity to lose S-Corp tax status. Moreover, an LLC that changes from Partnership to S-Corp taxation cannot change its status again for 60 months. An LLC that chooses to file as an S Corp must file form 1120S each tax year. More information and links are available here.
If you are interested in having your Limited Liability Company taxed as an Subchapter S Corporation, we can advise you on the potential tax savings, assist you in preparing the filings, and draft or update your Operating Agreement to ensure a smooth transition. Please contact us for more information or to schedule an initial consultation.
