A limited liability company (LLC) is a legal entity formed under state law to run a business. It provides many of the advantages of a corporation (such as limited liability), but is easier to form and operate. For details, see LLC Basics. Whenever a business entity is created it automatically receives a form of tax treatment by default.
A multi-owner LLC is automatically taxed as a partnership by default, while LLCs with one owner are taxed like sole proprietorships (one-owner businesses). However, LLCs may choose to be taxed as a C corporation or S corporation. This is easily accomplished by filing a document called an election with the IRS. Once this is done, as far as the IRS is concerned, the LLC is the same as a corporation and it files the tax forms for that type of entity.
Most LLCs stick with their default form of taxation. But electing to be taxed as an S corporation can have tax advantages.
How S Corporations Are Taxed
Like a partnership, an S corporation is a pass-through entity—income and losses passes through the corporation to its owners’ personal tax returns. S corporations also report their income and deductions much like partnerships. An S corporation files an information return (Form 1120S) reporting the corporation’s income, deductions, profits, losses, and tax credits for the year. Shareholders must be provided a Schedule K-1 listing their shares of the items on the corporation’s Form 1120S. The shareholders file Schedule E with their personal tax returns (Form 1040) showing their share of corporation income or losses.
Where S corporations really differ from partnerships is the employment status of owners who work in the business. The owner of an LLC taxed as a partnership is not an employee of the LLC for tax purposes. He or she is simply a business owner.
In contrast, an S corporation owner who performs more than minor services for the corporation will be its employee for tax purposes, as well as an owner. In effect, an active owner in an S corporation wears at least two hats: as a shareholder (owner) of the entity, and as an employee of that entity.
An owner/employee must be compensated for his or her services with a reasonable salary and any other employee compensation the corporation wants to provide. The owner/employee must report any S corporation’s earnings on his or her personal income tax return, and pay his or her share of Social Security and Medicare taxes on any employee salary paid. The corporation must withhold federal income and employment tax from the owner/employee’s pay, and pay state and federal unemployment taxes and Social Security and Medicare taxes on the employee’s behalf.
The Social Security and Medicare tax rate for an employee is the same as for a self-employed business owner; however, it’s paid differently. Half the total tax is deducted by the employer from the employee’s pay, and half is paid by the employer itself. When you own the business that is paying these taxes, it makes no practical difference that half is paid by the employer—you are the employer.
Being classified as an S corporation employee has one potential big advantage: S corporation tax treatment can provide a way to take some money out of your business without paying employment taxes. This is because you do not have to pay employment tax on distributions (dividends) from your S corporation—that is, on earnings and profits that pass through the corporation to you as an owner, not as an employee in compensation for your services. The larger your distribution, the less employment tax you’ll pay. The S corporation is the only business form that makes it possible for its owners to save on Social Security and Medicare taxes. This is the main reason S corporations have been, and remain, popular with professionals.
Example: Mel forms an LLC to operate his accounting practice and elects to have it taxed as an S Corporation. Mel is an employee of the LLC and receives a $100,000 salary. The remaining $100,000 of the business's profits are passed through the S corporation and reported as an S corporation distribution on Mel’s personal income tax return, not as employee salary. Because it is not viewed as employee wages, neither Mel nor his corporation need to pay Social Security or Medicare tax on this amount. Mel and his corporation only pay a total of $15,300 in employment taxes (15.3% x $100,000 = $15,300). Had Mel not elected S corporation status for his LLC, he would have had to pay self-employment tax on his entire $200,000 profit. This would have required him to pay an additional $2,900 in Medicare taxes and $1,252 in Social Security taxes.
If you took no salary at all, you would not owe any Social Security and Medicare taxes. As you might expect, however, this is not allowed. The IRS requires S corporation shareholder-employees to pay themselves a reasonable salary—at least what other businesses pay for similar services.
How to Elect S Corporation Status
No business entity starts out with the S corporation form of taxation. Instead, you must obtain it by filing an election with the IRS. This simply involves filing IRS Form 2553 with the IRS. However, S corporation status is allowed only if:
- the entity has no more than 100 shareholders
- none of the entity's shareholders are nonresident aliens—that is, noncitizens who don’t live in the United States
- the entity has only one class of stock—for example, there can’t be preferred stock giving some shareholders special rights, and
- none of the entity's shareholders are other corporations or partnerships.
These requirements pose no problem for most small businesses.