Business owners know that structuring your business can be challenging. Here is how to tell whether to file as a Limited Liability Company (LLC), or to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code, otherwise known as an S Corporation.
What is an LLC?
An LLC is a business entity that is legally separate from its owners, who are known as “members.” An LLC can have one member or many members.
Small business owners often choose an LLC instead of a corporation because LLCs offer more flexibility in the way they are managed and usually have fewer recordkeeping and reporting obligations than corporations.
What is an S corporation?
Unlike an LLC or a C corporation, an S corporation is not a type of business entity. The S corp. designation refers to the way a business has chosen to be taxed under the Internal Revenue Code.
Tax benefits of S Corp. vs. LLC
For tax purposes, the IRS classifies businesses as sole proprietorships, partnerships, C corporations, or S corporations. There is no “LLC” tax classification and, therefore, LLCs are taxed as though they are another type of business.
The IRS automatically taxes single-member LLCs as sole proprietorships and multi-member LLCs as partnerships. But an LLC can also choose to be taxed as a C corporation or as an S corporation.
What’s the difference between sole proprietorship LLC taxes and LLC taxed as S corporation taxes? For many small businesses, the main difference is in the way business owners pay Medicare and Social Security taxes—also known as “self-employment taxes.” Some LLC owners can save money on these taxes by choosing S corp. taxation.
Single-Member LLC Taxed as a Sole Proprietorship
The LLC member reports business income and expenses on his or her personal income tax return and pays personal income tax on company profits. The member is considered self-employed and thus is responsible for paying Social Security and Medicare taxes on those profits.
(Self-employed individuals pay a Social Security tax and Medicare tax on all income. Employees are subject to these same taxes, but the employer pays half and the employee pays half.)
Single-Member LLC Taxed as an S Corporation
The member can be considered an employee of the business. An owner-employee must be paid a reasonable salary. The LLC will report the salary as a business expense, and the owner will report both the salary and any remaining business profit on his or her personal tax return.
However, unlike the sole proprietor LLC owner who must pay Medicare and Social Security taxes on all profits, the S corporation and its owner will only pay these taxes on the owner’s salary. The remaining profits are not subject to these taxes.
Which is Right for You?
The IRS’s S corporation definition makes it clear that not every business qualifies to be taxed as an S corp. Most single-member LLCs will qualify, but you can’t choose S corp. taxes if:
- It is a foreign LLC
- The owner is a nonresident alien
- It is structured so that the owner is actually a corporation or partnership
(Multi-member LLCs that have more than 100 members also cannot be taxed as S corporations.)
To evaluate the benefits of S corp. vs. LLC taxation, you must consider whether changing to S corp. tax status will save you money. Find out what a reasonable salary would be for a person who does what you do. The IRS scrutinizes owner-shareholder salaries, so it is important not to set an artificially low salary for yourself. Then ask, if you paid yourself that salary, would your business have any profit left over? If the answer is no, then S corp. taxation may not help you.
If your business profits are greater than your reasonable salary, S corp. taxation may save you money. Consider also that your tax return will be somewhat more complex and, if you don’t have other employees, you will have to set up tax withholding. An accountant can advise you on other benefits and consequences of choosing LLC vs. S corp. taxation for your business.
So, LLC or S Corp?
If you’ve already formed your LLC but are unhappy with the tax consequences headed your way, you can change your tax status. In general, you can elect LLC S corp. status at any time during the tax year prior to the year you want the election to take effect, or during the first two and a half months of the current year.
Before deciding on S corporation or LLC taxation, be sure you carefully evaluate the various pros and cons and seek advice from a business lawyer or accountant.