If you have a limited liability company (LLC), electing to tax it an S corporation could be helpful. Numerous factors could help your decision. How do you treat your income? Will you use some of it as dividends? We’ll take a look at some of the pros and cons of an LLC taxed as S corp and see if it’s right for your business.
The LLC business entity has some appealing advantages over its alternatives. They include:
- Limiting liability. Hence the name. LLC owners have limited personal liability for debts owed by the business. Typically, liability is no more than the amount each invested in the business. Partnership owners and sole proprietors may be personally liable for all business debts.
- Avoiding double taxation. An LLC is a pass-through entity. Its income passes straight to the owners as self-employment income, avoiding corporate income tax.
- Minimizing paperwork and overhead. Compared to a regular corporation, an LLC has fewer record-keeping and meeting requirements.
Tax Treatment of LLC Income
When an LLC opts for an S corporation tax structure, it typically changes the way the IRS treats that LLC’s income.
When income from LLCs passes through to owners, they pay tax on it as self-employment income. The self-employment tax comes to 15.3%, with Social Security representing 12.4% and Medicare tax representing 2.9%.
As anyone who’s checked their pay stub knows, self-employment taxes are higher than Social Security and Medicare taxes paid by workers who aren’t self-employed. As a result, employees withhold just 6.2% for Social Security and 1.45% for Medicare. That’s because employers pay another 6.2% for Social Security and 1.45% for Medicare without passing it onto employees. Self-employed people pay both halves.
There are two more key factors to consider here:
- Income from a corporation is treated as a dividend rather than earnings. That means dividend recipients don’t have to pay Social Security and Medicare taxes on that income.
- The owner of an S corporation can let some of their business profits pass through as earnings. Meanwhile, other profits pay out as dividends that are free of self-employment tax.
By having LLC treated as an S Corp for tax purposes, a business owner may save a considerable amount in tax payments.
How LLC Taxed as S Corp Works
Say you are sole member of an LLC that earns $100,000 in net income. All $100,000 will pass through to you as self-employment income. In addition to income taxes, you’ll owe self-employment tax of $15,300, or 15.3%.
If you have elected be taxed as an S corporation, you might have $50,000 pass through as earnings and $50,000 distributed as dividends. Then you’d owe just $7,650 in self-employment tax, for a tax savings of $7,650.
Another potential advantage of an S corporation is that the Tax Cuts and Jobs Act made certain pass-through businesses eligible for a 20% Qualified Business Income deduction. This can produce additional tax savings not available to C corporations.
These potential tax benefits are the main reason LLCs elect to be taxed as S corporations.
Choosing LLC Tax Status
An LLC can choose an S corporation tax structure because an LLC is a business entity defined by state law. Meanwhile, S corp describes how the IRS treats a business for tax purposes. If the LLC doesn’t choose, the IRS applies a default tax structure depending on the number of members of the LLC.
- A single-member LLC will by default be treated as a sole proprietor by the IRS.
- An LLC with more than one member will default to partnership status.
An LLC can choose to be treated as an S corporation in a two-step process:
- File a Form 8832, Entity Classification Election. This causes the business to be taxed as a C corporation.
- Then file a Form 2553 to elect an S corporation tax structure.
S Corporation Disadvantages and Limits
Despite the potential benefits, S corporation status for an LLC isn’t a no-brainer. First, not all LLCs are eligible for S corporation status. Only U.S. corporations with no more than 100 owners, all of whom are U.S. residents, can choose S corporation status. Plus, they can only have a single class of shareholders. These restrictions can prevent an S corporation from attracting investors.
There are also added administrative costs. S corporations have extra recordkeeping and meeting requirements compared to sole proprietorships. However, the paperwork burden is lighter than for C corporations.
Meanwhile, earnings determine caps on annual IRA or other retirement plan contributions. So the more you take in dividends, the less you can put into a tax-advantaged plan.
S corporations are also somewhat more prone to IRS. audits And, if the IRS determines you aren’t paying yourself a reasonable salary, it may reclassify some dividends as earnings. Then you might owe self-employment tax plus penalty and interest on those.
The Bottom Line
The S corporation is the only business tax status that lets you save on Social Security and Medicare taxes while avoiding double taxation. An LLC taxed as S corp offers benefits of a corporation while also providing flexibility on income treatment. If you want to operate on the most bare-bones, tax-stingy structure possible, an LLC taxed as S corp may be right for you.
- If you’re wondering if an LLC taxed as S corp is the right path for your business, consider consulting a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Choosing an LLC taxed as S corp is a complex matter. While benefits often outweigh costs, you should talk to a professional tax advisor before choosing. However, SmartAsset’s tax guide can help you figure out some of the liabilities before you consult a pro.
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