Should I Elect S Corp Status for my LLC?

If you’re an LLC, electing S corp status might be on your business’s horizon. But is it time to elect S corp status? How do you file for S corp status? Is it better to be an S corp or a standard LLC? In this guide, we’ll cover all the essentials to becoming an LLC with S corp election.

Is an LLC allowed to elect S Corp tax status?

Many limited liability companies (LLCs) — but not all — can elect S corp status. They have to meet the IRS criteria, though. To qualify, the LLC must have 100 members or fewer (called “eligible shareholders”), only one class of members, and members can only be individuals, certain trusts, or estates. Other entities and non-resident aliens can’t be members of the LLC. There are also a couple entity types, such as insurance agencies or financial institutions, that can’t qualify.

LLC vs S Corp

There’s one very crucial distinction we should make you aware of when comparing LLCs and S corps. Technically, it’s not even fair to “compare” them because they’re two distinct categories: an LLC is a legal entity type and an S corporation (please see our What is an S Corp? page) is a tax classification that different business entities can opt into.

That said, a standard LLC and an LLC taxed like an S corp do have some key differences. The most important one is the tax burden of the members. In an LLC with a default classification for taxes, the members receive distributions from the business income as their pay, which is taxable income. They’ll owe income taxes and self-employment taxes on the entire distribution they receive.

In contrast, members of an S corp can be treated as employees of the entity. They can pay themselves a reasonable salary and then give themselves any remaining profits through a distribution (usually in accordance with their ownership percentage). This structure gives a break on self-employment taxes because those taxes will only be levied on the salary income only. Each distribution is treated like a dividend for tax purposes. Dividend income isn’t considered to be self-employment income. Of course, this is only for self-employment taxes; LLC members still must pay income and other applicable taxes on their dividends.

Related:

Can an S Corporation Own an LLC?

How to Change an LLC to an S Corp

When to Elect S Corp Tax Status for an LLC

There isn’t a one-size-fits-all answer for when you should elect S corp status, but there are a few criteria that any business owner should consider:

• You’ve been in business long enough to reasonably predict what your annual revenue will be. If your current profits wouldn’t let you pay yourself a “reasonable salary” for your industry yet, it’s probably best to put it off (more on this later).

• Your total profits are big enough that you would benefit from the tax breaks of S corp status. Self-employment tax rates are currently 15.3%, so S corp status may or may not save you money depending on your income. This is primarily important for federal tax purposes.
• You are prepared to maintain careful, detailed financial records, either on your own or by hiring a bookkeeper. The IRS scrutinizes tax returns for S corps more closely, so it’s essential to be prepared in case of an audit or other tax penalties.
• It’s been less than 75 days after the last tax year ended, or you’re willing to wait for the S corporation status to come into effect the following tax year. You can also elect this status up to 75 days after forming your LLC, if you want.

While those aren’t the only reasons you might be ready for an S corporation, they’re pretty good indicators. If you’re unsure if becoming an S corporation owner will actually save you money on taxes, we recommend consulting with a licensed accountant or tax attorney. They’ll walk you through the specifics of how the status will affect your wages, your distributions, and any other tax benefits.

Benefits of S Corp Tax Treatment

S corporation status comes with some notable perks, especially tax advantages. One of the biggest potential benefits is that the members who are running the LLC can partially pay themselves like employees, greatly reducing their self-employment tax burden. S corporations are also taxed like partnerships (or sole proprietors for single-member LLCs), which means they’re subject to pass-through taxation for federal income tax purposes (see pass-through taxation definition). The LLC itself doesn’t pay taxes; the members do by reporting their LLC income on their personal income tax returns. This approach also avoids the double-taxation of a regular corporation, and in some cases avoids higher corporate tax rates.

As an added plus, electing S corporation status doesn’t change the day-to-day way a corporation is run. The entity itself is still more flexible than a corporation. Plus, all the members still get personal liability protection because electing S corp status doesn’t affect liability or the company’s structure, only taxes. In a way, an S corporation tax election gives an LLC the best of both worlds.

Drawbacks of S Corp Election

There are a few downsides to electing S corp status, though. For one, you can only have a limited number of members. And your members can only be individual residents of the U.S. (with a few exceptions). Those requirements somewhat limit the investments you can get.

More importantly, S corporations are much more likely to get audited because the IRS monitors them closely so the potential tax benefits aren’t abused. For a compliant LLC, this isn’t a huge issue. But audits are stressful for anyone. And if the LLC hasn’t adhered to the IRS’s corporation rules for taxes, an audit can spell disaster.

One thing the IRS particularly pays attention to is whether the LLC members in an S corp are paying themselves a “reasonable salary” as employees of the LLC. Otherwise, they could pay themselves an annual salary of $1 and avoid contributing anything to Social Security and Medicare. The IRS doesn’t give a crystal-clear definition of what it considers a “reasonable” salary to be, but, generally speaking, it’s something similar to what others in the same field are earning for the same work.

How to Elect S Corp Taxation for an LLC

Electing S corp status as an LLC is actually relatively simple. All it really entails is filing one or two forms. If you’re within 75 days of forming your LLC, all you have to do is submit IRS Form 2553, Election by a Small Business Corporation. If more time has passed, you’ll file that form and IRS Form 8832, Entity Classification Election, at the same time. This second form essentially informs the IRS that you’re opting in for a type of corporation taxation.

You should also check with your state agencies to find out if there are any additional requirements at the state level. It’s also a good idea to add this status to your operating agreement.

We can help!

Electing S corporation status doesn’t have to feel overwhelming — ZenBusiness has your back. Whether you need help forming your LLC, managing your LLC’s finances with our Money app, or staying compliant every year, we can support you every step of the way.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.