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By The Wyoming LLC Attorney Team

Feb 29, 2024
  1. LLC Taxes

LLC Electing S Corporation Tax Status: An Option Few People Know About

How to Start an LLC


This article explores the option of electing S corporation tax status for Limited Liability Companies (LLCs), discussing the benefits of LLCs, the perks of operating as an LLC taxed as an S corp, and the tax implications involved. It compares S corporation status to sole proprietorship or partnership tax structures and provides considerations for LLCs deciding whether to opt for S corporation designation.

In the complex landscape of business structures, Limited Liability Companies (LLCs) stand out due to their versatile nature. An intriguing aspect of LLCs is their ability to elect for S corporation tax status, providing a unique set of benefits that may be unknown to many entrepreneurs. Now let’s delve into the considerations involved in establishing an LLC, explore the tax implications under different tax statuses, and examine the process involved when an LLC opts for S corporation status:

​​Real World Example

We’d like to illustrate this via a case example. Jane, a professional graphic designer, launched her design firm as a sole proprietorship. However, as her clientele grew, she wanted to shield her personal assets from potential business liabilities. After consulting with a business attorney, she established her business as an LLC. As her revenues soared, Jane became aware of the hefty self-employment taxes she was facing. After in-depth discussions with her tax advisor, she elected for her LLC to be taxed as an S corporation. This allowed her to classify a portion of her income as dividends, lowering her overall tax burden while maintaining the liability protection offered by her LLC.

Motivations Behind Establishing an LLC: Enhanced Liability Protection and Versatility

The primary motivations for establishing a Limited Liability Company (LLC) lie in the enhanced liability protection and the flexibility it provides. One of the significant benefits of an LLC is that it allows for limited liability for its members, providing a safeguard for personal assets against business debts and claims. It creates a legal separation between the business and its owners. Further, the flexibility inherent in an LLC structure is a significant draw for many businesses. With fewer formalities and regulations than a traditional corporation, LLCs offer a more relaxed operational model. Additionally, the structure permits flexibility in taxation, with options to be taxed as a disregarded entity, partnership, or corporation.

Exploring the Perks of Operating as an LLC

Operating as an LLC delivers a multitude of advantages valuable for businesses of all scales, and becoming an LLC taxed as an S corp can amplify these benefits. The defining feature of an LLC is the limited liability protection it extends to its members, ensuring their personal assets are shielded from business debts or litigations. This safeguarding offers a sense of security to owners. In addition to liability protection, LLCs enjoy the benefit of pass-through taxation, bypassing the problem of double taxation experienced by conventional corporations. The flexibility inherent in the operation of an LLC facilitates easier management and adaptation to evolving business environments. Crucially, if an LLC chooses to be taxed as an S corp, it introduces a new dimension of flexibility and potential tax benefits that align with strategic business objectives.

Unpacking the Taxation Process of an LLC

The taxation process for an LLC is nuanced, warranting careful examination. By default, the Internal Revenue Service (IRS) treats an LLC as a "disregarded entity" for tax purposes. This means that in the case of a single-member LLC, income and losses are reported directly on the owner's personal income tax return, much like a sole proprietorship. For multi-member LLCs, the IRS automatically treats them as partnerships for tax purposes, and earnings and losses are passed through to the members accordingly. However, an LLC has the flexibility to opt for alternative tax classifications, such as being taxed as an S corporation, which can provide distinct tax benefits.

Pre-set Tax Classification for an LLC

The pre-set tax classification of an LLC depends largely on the number of members within the company. A single-member LLC is automatically treated as a disregarded entity, similar to a sole proprietorship, for tax purposes. Conversely, a multi-member LLC is taxed as a partnership by default. However, it's important to note that an LLC is not bound by these defaults. It has the flexibility to elect corporate or S corporation tax status if such classifications align better with the business's financial strategy and objectives. This potential to choose a tax classification provides an LLC with a considerable degree of control over its tax liability.

Exploring the Tax Implications When an LLC Is Categorized as a Corporation

When an LLC elects to be taxed as a corporation, there are notable tax implications. This decision transforms the LLC from a pass-through entity to a taxable entity at the corporate level. Consequently, the LLC's profits are subject to the corporate income tax rate. Then, when these profits are distributed to members as dividends, they are taxed again at the individual level. This double taxation is a critical consideration for LLCs considering corporate tax status. However, the opportunity to retain earnings within the corporation, coupled with potential benefits from corporate tax deductions, could make this election beneficial under certain circumstances.

Considerations When an LLC Is Taxed as an S Corporation

LLCs that elect to be taxed as an S corporation must weigh several considerations. While the S corporation tax status allows for pass-through taxation, circumventing double taxation seen in traditional corporations, it also requires that the LLC meet specific IRS criteria. For instance, the LLC cannot have more than 100 shareholders, and all shareholders must be U.S. citizens or residents. Furthermore, taxation as an S corporation necessitates that owners pay themselves reasonable salaries if they perform services for the LLC, which are subject to employment taxes. The balance between the potential tax advantages and the regulatory requirements should be evaluated carefully.

Comparing Tax Implications: S Corporation vs Sole Proprietorship or Partnership

The tax implications of an S corporation stand in contrast to those of a sole proprietorship or partnership. Under an S corporation status, only the salary paid to owner-employees is subject to employment taxes. The remaining income is treated as a distribution, which may lead to potential tax savings. In contrast, in a sole proprietorship or partnership, owners must pay self-employment taxes on the entire net income of the business. Thus, if an LLC is generating significant income, electing to be taxed as an S corporation can reduce the overall tax burden by separating the owner's compensation into salary and dividend income.

The Upside to Choosing S Corporation Status

Electing S corporation status can be beneficial for an LLC for several reasons. Perhaps the most significant benefit is the potential tax savings. Under S corporation status, an LLC can distribute part of the income as dividends, which are not subject to self-employment taxes, potentially leading to significant savings. Moreover, S corporation status allows the entity to issue stock, which can be a crucial advantage when raising capital. However, it's essential to keep in mind that these benefits come with increased regulatory requirements and formalities. As always, the specific circumstances of the LLC should guide the decision-making process.

Should Your LLC Opt for S Corporation Designation?

The decision for an LLC to elect S corporation status should be informed by careful deliberation and business-specific considerations. While the potential tax savings can be significant, there are added complexities and regulations that come with S corporation status. These include stipulations regarding the type and number of shareholders, and the requirement to pay a reasonable salary to owners who are active in the business. If the LLC has a high net income and can benefit from lower self-employment taxes, S corporation status may be a viable option. It's advisable for business owners to consult with a tax advisor or an attorney to fully understand the implications and potential benefits of this election for their specific situation.

Tax Filing Procedures for an LLC With an S Corporation Election

If an LLC elects S corporation status, the tax filing procedures change accordingly. Instead of filing a Schedule C, as sole proprietors do, the S corporation must file Form 1120S, an income tax return for an S corporation. Additionally, each shareholder receives a Schedule K-1 outlining their share of the S corporation's income, losses, deductions, and credits. Shareholders then report this information on their personal tax returns. Therefore, while an S corporation election may lead to tax savings, it also involves a more complex tax filing process. This underscores the importance of enlisting professional tax advice when considering such a transition.

Final Thought

Choosing the appropriate business structure and tax status is pivotal to a company's success. While the decision to form an LLC offers benefits such as limited liability protection and operational flexibility, the choice to elect S corporation tax status introduces a new set of opportunities and challenges. Balancing these elements requires a deep understanding of the intricacies involved and often necessitates professional guidance.

By remaining informed, businesses can make strategic decisions that best align with their financial and operational objectives. If you're in the early stages of formation and prepared to create an LLC, begin the process with a simple click. For any questions, contact us through our online form or by dialing +1 (307) 683-0983.