Should your LLC be taxed as a subchapter S corporation?

If you are a business owner and you chose the “limited liability company” form of entity, you were probably motivated by three key characteristics of an LLC:

• protection from personal liability for the company’s obligations;
• relatively little formality or reporting to government entities; and
• avoidance of double taxation.

Other popular features of an LLC are its existence as a separate legal entity, apart from the owner(s); perpetuity of existence; flexibility in management structure; and freedom in transferring financial interests.

For the purposes of this article, let’s get back to the subject of taxation.

Tax problem. An LLC is a pass-through entity; that is, instead of paying income taxes, its net profits and losses “pass through” to its member(s) via a Schedule K-1, the contents of which are reported on the individual income tax returns.

That is how LLC members – like partners in a partnership or shareholders in an S corporation – avoid the double-taxation issue that they would incur if they were shareholders in a C corporation.

That’s the good news.

The bad news: As a general rule, each member must pay self-employment taxes on their share of the LLC's profits – to the tune of 15.3% – regardless of whether they actually receive their share of the profits, which have already passed through to them.

S corp election. A popular solution to this dilemma is for the LLC to elect to be taxed as an S corporation. After the election is approved by the IRS (eligibility and process are discussed below):

1. The LLC pays each member a “reasonable salary” (also discussed below), which replaces the self-employment tax with conventional federal withholding and FICA taxes that are applied only to the salary amount(s). Half of the FICA taxes are paid by the LLC, while the other half is withheld from the members’ paychecks.
2. The member salaries and employment taxes are deducted from the LLC’s taxable profits.
3. The net profits (after salaries and employment taxes) pass through to the member(s).
4. The pass-through profits are still taxable to the member(s), but they are reduced by the salary and payroll tax deductions, and what passes through is not subject to payroll taxes.

Threshold. If your LLC does not generate much (if any) profits, the S corporation election is probably not worth the trouble.

In a single-member LLC, the election starts to make sense when the member’s aggregate self-employment tax burden is at least the same as the tax burden that the LLC would incur as an S corporation.

If a conventional single-member LLC is generating profits of at least $40,000, it’s worth doing the math. If profits exceed $60,000, you are likely to be better off as an S corporation taxpayer paying a reasonable salary to each member.

Reasonable salary. Because the IRS does not specifically define “reasonable salary,” you will be left to make that determination, with the guidance of your tax professional or business attorney.

Consider this standard: If you are involved full-time in the business of your LLC, pretend that you are going to step out of active involvement, and then estimate how much would you have to pay a non-member to take over your job. That would seem to be a reasonable salary to pay yourself now.

Eligibility. To qualify to be taxed as an S corporation, your LLC must meet certain requirements:

• formed in the U.S.;
• no more than 100 members;
• all members are individuals (i.e., not other LLCs, partnerships or corporations);
• all members are U.S. residents; and
• there can be only one class of membership interest.

The election. S corporation elections are initiated by filing IRS Form 8832 (Entity Classification Election), followed by IRS Form 2553 (Election by a Small Business Corporation) by March 15 of the year for which you wish to begin being taxed as an S corp.

Tax return. After the IRS has approved your election, your LLC would use IRS Form 1120-S (U.S. Income Tax Return for an S Corporation) to report its taxable income or losses. It would also provide each member with a Schedule K-1 that shows their pro-rata share of the LLC’s taxable activity.

Do it right. In theory, an LLC member can initiate the S corp election.

However, to achieve all of the desired benefits of owning an LLC and electing to be taxed as an S corp, seek the guidance of your business lawyer or tax professional, to ensure that the election:

• satisfies the IRS,
• aligns with the LLC’s operating agreement and other governing documents, and
• supports the interests, objectives, and tax situation of each member.

To determine whether an S corp election makes sense for your LLC, contact Ron Adams or Ryan Scharber.