Many of our clients ask us for advice on which entity they should choose for their business. Most of the time, these questions focus on the differences among a corporation, S-corporation, LLC, partnership, or sole proprietorship, and how to optimize the structure for both tax and liability purposes.
There are situations when the best choice may be to form as an LLC and then file an election for S-corporation tax treatment.
Generally, in a multi-member LLC taxed as a partnership or a single member LLC, all of an LLC’s economic gain will flow through to the individual owner’s personal tax return and remain subject to self-employment taxes. However, with an S-corporation, the portion of an LLC Member’s wages that are subject to self-employment taxes may be limited only to that Member’s reasonable compensation for the services provided.
Therefore, the major benefit derived from electing S-corporation tax treatment for your LLC is that only your wages are subject to self-employment taxes if the LLC is taxed as an S-corporation. Note, however, that your LLC would then have to comply with the ownership rules applicable to S-corporations, which tend to be less flexible than the rules surrounding LLCs. These rules are not typically a major obstacle for most small businesses. For example, an S-corporation may only have a single class of ownership, may not have any non-resident alien Members, and may not have corporations or partnerships as Members. Also, as a separate entity that is now an employer, the S-corporation must comply with all of the payroll tax withholding and reporting requirements for the wages paid.
Otherwise, though, the LLC still offers more flexibility of ownership and management than a corporation, because you will not, for example, need a Board of Directors or be required to hold annual meetings.
To receive the tax treatment of an S-Corporation, your LLC must file an election with the IRS using Form 2553. You must file Form 2553 within the first two months and fifteen days of (a) the beginning of the tax year in which the election is to take effect or (b) the formation of the entity. If you file the election late, then you may apply for late filing relief or simply acknowledge that your election will be effective for the next tax year.
If your business generates a nice profit over and above what the IRS would consider reasonable compensation for the services that the owners provide, then you may be unnecessarily subjecting the profits to self-employment taxes if you are operating as an LLC taxed as a partnership. If you think your business may fit this model, your LLC may benefit from choosing to be treated as an S-corporation. Given some of the state-law variations and analysis required, though, no decision should be made without discussing your own situation with a qualified professional.
For assistance with your LLC, or any other legal needs related to your business or estate planning, contact Fournier Legal Services for a free consultation at firstname.lastname@example.org or 860.670.3535.
Joe received his law degree from the University of North Carolina–Chapel Hill School of Law and his Accounting degree from the University of Rhode Island. He is admitted to practice law in Connecticut, Massachusetts, and Rhode Island, and he is a CPA. He is an Adjunct Professor and lecturer at the University level and has been a frequent speaker on business planning and legal matters.