A limited liability company (LLC) can choose to be taxed as an S corporation if it meets certain Internal Revenue Service (IRS) requirements. An LLC can also keep its default tax classification as a sole proprietorship or partnership, or it can elect to be treated as a C corporation.
Electing S corporation tax status is a simple procedure, but it's not always the right choice. For some LLC owners, an S corporation saves a significant amount of money at tax time. For others, an S corp adds another level of complexity and expense without any real benefits.
Because the decision to be taxed as a pass-through entity or corporation can have a significant financial impact, it's important to understand your tax options and how they might affect your particular business. This guide will help you get started.
Tax classifications vs. business types
The terms "LLC" and "S corporation" are often confusing for a new business owner. The first step in decidinghow your LLC should be taxedis to understand how a business can be both an LLC and an S corporation.
LLC, or limited liability company, refers to the type of business entity you set up with the state. A corporation is another common type of business entity. LLCs and corporations limit their owners' personal liability for business debts. The owners of an LLC are called members, while a corporation's owners are called shareholders.
Compared to corporations, limited liability companies have a more flexible ownership and management structure that's well-suited to many small businesses. Both limited liability companies and corporationsare formed by filing paperwork with the secretary of state orother state agency that handles business filings.
An S corporation is not a type of business structure that you establish when you form your business with the state.It is a tax classification. After an LLC or corporation has been officially formed, it can choose to be taxed as an S corporation by filing a form with the IRS.
Options for LLC taxes
Although many businesses are organized as LLCs, the IRS has never established a separate LLC tax classification. Instead, the IRS treats LLCs as though they were a different type of business for federal tax purposes. An LLC can file taxes as a sole proprietorship or a partnership. It can also elect corporate taxation and file taxes as a C corporation, or an S corporation. We'll break down each IRS tax classification by category.
Default LLC tax classifications
If you don't file any special forms with the IRS to change your tax classification for federal income tax purposes, your LLC will file taxes as either:
- A sole proprietorship,also known as a disregarded entity(if you are the only member) or
- A partnership (if your LLC has more than one member)
Single-member LLCs taxed as a sole proprietorship don't file an LLC tax return. They report income and expenses for the business on Schedule C of the member's personal tax return. The member is considered self-employed and therefore isresponsible for paying self-employment taxes, otherwise known as Social Security and Medicare taxes, in addition to federal and state income tax. These taxes should be paid through quarterly estimated tax payments.
Self-employment taxes are levied at a rate of 15.3% of net self-employment income, up to an annual limit. Income exceeding the limit is subject to the Medicare portion of the tax but not the Social Security portion.
The situation is similar for amulti member LLC taxed as a partnership, except that the LLC will file an informational partnership income tax return, and each member will be responsible for paying personal state and federal income taxes on their share of the LLC profits when they file their personal income tax returns.
How are LLCs taxed if they elect S corp taxation?
An S corporation is a pass-through entity for tax purposes. This means that if an LLC is taxed as an S corporation, the LLC doesn't pay corporate income tax. Instead, theLLC's profits pass through to the members, who report and pay tax on them when they file their personal income tax returns.
At first glance, this sounds similar to an LLC taxed as a sole proprietorship or partnership. But there is a key difference. If your LLC elects an S corporation tax structure, the LLC members are no longer self-employed and responsible for paying self-employment taxes—they can be employees of the LLC.
An LLC member employed by the LLC receives a salary. Income, Social Security, and Medicare (FICA) taxes are withheld from their paychecks, just as they would be with any employer. If the LLC makes a profit after it pays salaries and other expenses, those profits are reported on the members' personal tax returns as ordinary business income. Members pay income tax on ordinary business income, but they do not pay Medicare and Social Security taxes.
For a profitable LLC, the self-employment tax savings can be significant because members pay FICA taxes only on their salaries, not on the entire amount of the company's profit. An S corporation election can also enable owners to build more savings in retirement accounts.
But there's a catch: IRS tax rules require S corporation owners to pay themselves a reasonable salary. The IRS list of factors to consider in determining a reasonable salary includes training and experience, duties and responsibilities, time devoted to the business, contributions of non-shareholder employees, and what comparable businesses pay for similar services.
The IRS may give added scrutiny to the reasonableness of S corporation owner salaries. For this reason, it's a good idea to consult with a tax expert when establishing salaries for each LLC member.
Requirements to be an S corp for federal income tax purposes
Federal tax regulations limit the types of businesses eligible for S corporation taxation. To be an S corporation for federal tax purposes, your business must be a domestic (U.S.) corporation or LLC and must meet several other requirements:
- Have no more than 100 shareholders (or LLC members)
- Not have any shareholders (or LLC members) that are corporations, partnerships, or non-resident aliens
- Shareholders (or LLC members) can be individuals and certain trusts and estates
- Have only one class of stock
In addition, the business cannot be an ineligible corporation. Examples of ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations.
Limited liability company taxed as an S corp: Advantages and disadvantages
A major advantage of S corporation taxation is the ability to minimize self-employment taxes. Here's a simplified example to illustrate how this works: Suppose you have a single-member LLC taxed as a disregarded entity with $150,000 of profit. You'll pay self-employment taxes of 15.3% on this entire amount, in addition to income taxes.
Now suppose you elect S corporation taxation and pay yourself a reasonable salary of $90,000, leaving you with a business profit of $60,000. As an S corporation, you'll pay Medicare and Social Security taxes on your $90,000 salary, but not on the additional $60,000 business profit, saving you over $9,000.
Other advantages of S corporation taxation include:
- Owners can increase retirement savings by having the business contribute to employee retirement accounts
- Owners don't have to make estimated self-employment tax and income tax payments on their salaries
However, electing S corporation status adds some costs to your business. If your profits barely exceed your reasonable salary, being an S corporation may increase your administrative burdens without saving you significant amounts of money. Here are some of the costs and disadvantages of an S corporation compared to the default tax structure:
- If you don't already have other employees, you'll have to start running payroll
- S corporation tax returns are more complicated and typically need to be prepared by a tax professional
- Benefits such as health insurance provided to owners/employees who own more than 2% of the business are considered taxable income
- Your LLC and its operating agreement need to be structured in a way that is consistent with S corp taxation
Changing your business tax status is a major decision that should only be made after discussing your specific situationwith a legal and/or tax expert. Every business is different, and it's a mistake to assume you need to be an S corp just because other businesses are.
Limited liability company (LLC) taxed as a C corp
The final tax option for an LLC is to elect to be taxed as a C corporation. If your LLC is taxed as a C corporation, you can be a company employee, just as with an S corp. But there's a dramatic difference in the way business income is taxed.
C corporations file corporate income tax returns and pay corporate income tax on company profits. Shareholders (or members) also pay personal federal and state income taxes on dividends that are paid out to them. This double taxation of dividends at both the corporate and personal level is frequently cited as a drawback of C corporation taxation for small businesses. In contrast, S corp profits pass through to the owners for tax purposes and are taxed only on the owners' personal returns.
How to elect S corp status and file an income tax return
An LLC can elect S corporation taxation by filing Form 2553, Election by a Small Business Corporation. It must be signed by all the members and can be submitted by mail or fax. The form must be filed no more than two months and 15 days after the start of the tax year it is to take effect, or at any time during the previous tax year.
The Internal Revenue Service (IRS) will notify the LLC whether its election has been accepted and when it will take effect. The election remains in effect until it is terminated or revoked.
An LLC that has elected to be taxed as an S corporation must file a corporation income tax return on Form 1120S. The return is due on March 15 each year (or the next business day if March 15 falls on a Saturday, Sunday, or holiday). Form 1120S reports the income, gains, losses, deductions, credits, and other information for the LLC.
Because an S corporation is a pass-through entity, corporate taxes aren't paid when the return is filed. The information on form 1120S becomes the basis for K-1 schedules that the LLC must provide to each member. Schedule K-1 shows each member's share of the S corporation's income, deductions, and credits. Members use this information to report business income on their personal taxes.
Should my LLC be taxed as an S or C corp?
It's more common for a small business LLC to elect to be taxed as an S corp than it is to choose C corp taxes. Because of the double taxation of C corp distributions, many small business owners will pay less in taxes if they are taxed as an S corp.
However, if you plan to keep profits within the company—perhaps to fund a future expansion—rather than distributing them to the owners, it might be advantageous to be a C corp and pay taxes at the corporate tax rate. C corp taxation can also be preferable if you're seeking outside investment that could disqualify you from being taxed as an S corporation.
Business taxes can be complex, and your tax choices may have a big impact on your bottom line. Having your LLC taxed as a corporation is an important decision. It's best to consult regularly with a tax professional to make sure your LLC is being taxed in the way that's best for your current situation.
How do I know if my LLC is an S corp or a C corp?
If you filed an entity classification election form to be taxed as either an S corp or a C corp, you should have received a notice from the IRS within about two months of your filing. The notice will either say that your election was accepted and provide its effective date, or it will say that your election was not accepted. If you filed an election form and haven't received a notice, you can contact the IRS by phone for a status update.
If you have never filed a form with the IRS electing corporate taxation, your LLC is neither an S corp nor a C corp. If you're the only member, your LLC is a disregarded entity taxed as a sole proprietorship. If you have a multi member LLC,it's taxed as a partnership.
And if you've filed a tax return in the past, you can refer to last year's tax return to identify how you pay taxes. If you're an S corp, your taxes are filed on form 1120S. A C corporation files form 1120.
Is an LLC taxed as a C corp allowed to have 1099 contractors?
Yes, a C corporation can have contractors who are issued a Form 1099. However, it's important to follow IRS tax rules about the proper classification of workers as either employees or contractors. If you aren't sure how to classify someone, a tax attorney can help.
Does an LLC owe sales tax or franchise tax?
If your LLC sells taxable goods, it will be responsible for collecting sales taxes and forwarding them to the appropriate government taxing agency. This is true regardless of the LLC's federal tax classification. The sales tax rate is established by state and local governments, and some states don't have a sales tax at all. Sales tax rates and regulations vary depending on where your LLC conducts business.
Some states impose an annual tax known as a franchise tax on certain business entities. For example, California has a mandatory minimum $800 franchise tax for LLCs, regardless of their federal tax classification. Franchise tax rates, the business types they apply to, and the way they're calculated vary by state. Contact your state taxing agency to find out whether your LLC is subject to franchise tax.
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