A limited liability company (LLC) is a legal entity that has the advantages of a corporation (such as limited liability) but is easier to form and operate. All LLCs automatically receive a form of tax treatment by default.
A multi-owner LLC is automatically taxed as a partnership by default, while an LLC with one owner is taxed like a sole proprietorship (one-owner business). However, LLCs may choose to be taxed as a C corporation or S corporation 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 same tax forms as a corporation.
Most LLCs stick with their default form of taxation. Why choose an S Corporation? Because electing to be taxed as an S corporation can have tax advantages. This can be especially true as a result of the new pass-through tax deduction created by the Tax Cuts and Jobs Act.
An S Corporation isn't a type of legal entity like an LLC or a corporation that you form at the state level. Instead, an S Corp is essentially a tax status recognized by the IRS. LLCs and some corporations can elect S Corporation tax status by filing paperwork with the IRS, as discussed below.
Like a partnership, an S corporation is a pass-through entity—income and losses pass 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. S Corp owners must provide shareholders 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 corporate 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.
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.
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.
Being classified as an S corporation employee has a potentially 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. Historically, this has been the main reason S corporations have been popular.
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. Moreover, due to the pass-through tax deduction discussed below, it can be advantageous for an S corporation to pay substantial employee salaries.
The Tax Cuts and Jobs Act established a brand new tax deduction for businesses owned through pass-through entities: sole proprietorships, partnerships, LLCs, and S corporations. Starting in 2018, owners of such entities may deduct up to 20% of their net business income from their income taxes. This is a personal deduction all pass-through business owners may take whether or not they itemize.
You qualify for the 20% deduction only if your total taxable income for the year is less than $157,500 (single) or $315,000 (married, filing jointly). If your taxable income is greater than $207,500 (single) or $415,000 (married), you don't qualify for the pass-through deduction unless your business pays employee wages or has business property. In this event, your deduction is limited to the greater of:
Here's one of the benefits of S corp taxation. As described above, when you elect S corporation status, you work as your business's employee and are paid W2 wages. These wages can enable you to qualify for the pass-through deduction.
Unfortunately, the strategy outlined above doesn't work if you are involved in a personal service business, such as:
The pass-through deduction is not available for such businesses where the owner's taxable income is over $415,000 for married individuals or $207,500 for singles. The pass-through deduction is gradually phased out for these taxpayers when their taxable income exceeds the $315,000/$157,500 thresholds. This is intended to prevent highly compensated employees who provide personal services—lawyers, for example--from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction.
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 Form 2553, Election by a Small Business Corporation, with the IRS. However, your business may qualify for S corporation status only if:
These requirements pose no problem for most small businesses. If you want S corporation status to apply to the entire calendar year, you must file Form 2553 by March 15—the filing is retroactive to January 1.
You have a lot to consider before deciding if an S Corp is the right option for your LLC. For more information, check out Five Questions to Ask Before Forming an S Corporation, and S Corporation Tax Filing Requirements.