The default federal tax status for a single-member limited liability company (SMLLC) is disregarded entity. However, the owner of an SMLLC can elect to have the business taxed as either a traditional C corporation or as an S corporation. An S corporation is a special type of small, closely-held corporation. This article briefly covers SMLLCs taxed as S corporations.
An S corporation, like a typical LLC or sole proprietorship (but unlike a traditional corporation), is subject to pass-through taxation. In other words, the responsibility for paying income tax passes through the business to you personally.
To elect S corporation tax status, you need to file IRS Form 2553, Election by a Small Business Corporation. You can file an election for S corporation tax status at any time after setting up your SMLLC. However, there are limitations on when the election can take effect. Specifically, your S corporation tax status must become effective within the 75-day period before you file the form or within 12 months after you file it. Electing S corporation tax status means you'll have to file additional tax documents each year, such as Form 1120S, U.S. Income Tax Return for an S Corporation.
Both SMLLCs and S corporations have pass-through taxation. Moreover, being taxed as an S corporation involves more paperwork than an SMLLC. So why would you choose S corporation tax status? The most common answer is: As a way to reduce self-employment taxes while keeping pass-through taxation. As the owner of an SMLLC classified as an S corporation you are not considered a self-employed individual and are not subject to federal self-employment tax. Instead, you are considered to be an employee, and—the key point—you can take some, but not necessarily all, available profits from your company as a salary.
Other SMLLC profit, if any, can be taken as a dividend, which is not subject to any employment-related taxes, nor—unlike with a C corporation—to double taxation. By contrast, all profit from a SMLLC classified as a disregarded entity is subject to self-employment tax. In short, if your SMLLC is classified as an S corporation for tax purposes, you'll avoid employment taxes on money you receive from the company in the form of a dividend.
In light of the fact that, with a SMLLC taxed as an S corporation, you pay employment-related taxes on a salary but not on dividends, you might think that you should just take all your money from the SMLLC as a dividend, and thus avoid paying self-employment taxes altogether. This approach, however, is prohibited. The IRS is very clear that you must pay yourself at least "reasonable compensation."
For various reasons, choosing S corporation status strictly to try to save on self-employment taxes can be a questionable proposition. However, if you're seriously considering this approach, you should check with both a lawyer and a tax expert to make sure your SMLLC is properly organized, meets all IRS guidelines, and that re-classification is financially worth your while.
It can be difficult to know when compensation is reasonable. In one important legal case, the court listed nine different factors that might be considered in determining the reasonableness of compensation. Similarly, the IRS currently has a list of ten factors. By way of trying to ensure that compensation will pass muster as "reasonable," some accountants apply a 60/40 rule, where at least 60% (a clear majority) of profit is taken as salary and the rest as a dividend. It can also be useful to check for information on comparable businesses using sources like the U.S. Bureau of Labor Statistics or employment agencies.
EXAMPLE: Simon formed her gourmet catering business ten years ago as an SMLLC. Six years later, he elected to have it taxed as an S corporation. Last year the business did very well and he had a net profit of $100,000. He knows that other people doing the same kind of work normally earn $50,000-$60,000 per year. He also checked with some government websites and his accountant for additional confirmation that $60,000 is a reasonable salary. He then paid himself a salary for the year of $60,000 (making sure to have his SMLLC deduct employer taxes for Social Security and Medicare, and also making sure to pay his own share of those taxes on his personal tax return). Simon took the remaining $40,000 as a dividend—and didn't have to pay any employment taxes on that money.
For additional information on any of the issues covered here, including avoidance of self-employment taxes and reasonable salaries, check irs.gov or consult with a tax professional. For other general information related to taxation of SMLLCs, check out the other tax-related articles in the SMLLC section of this website.