Numerous small businesses today are organized as a limited liability company (LLC). An LLC offers flexibility when organizing the management and economic structure of an entity. Due in large part to this flexibility, the LLC has become the most popular choice of entity to form when seeking limited liability protection for new small businesses. Below we’ve put together some information to help you decide whether to elect to be an LLC taxed as an S corporation.
Key Distinctions between S Corporations and LLCs
When deciding how your small business should be taxed it is important to understand the distinctions between S corporations and LLCs. An S corporation refers to the tax treatment of an entity. An S corporation is not a type of entity, but a type of tax status—specifically, subchapter S of the U.S. Tax Code governs the tax treatment of entities that elect to be taxed as an S Corporation.
An LLC, on the other hand, is a type of limited liability entity that is governed by state statutes and offers the owners (commonly referred to as “members”) limited liability protection when acting on behalf of the business.
When you first form your entity, you can elect for the entity to be taxed as an S corporation by simply filing a form with the IRS. By filing the form, your small business can elect to become a pass-through entity, which means that any income (or loss) will pass through the entity and be allocated to the owners of the business as individual income (or loss) and subject to self-employment taxes.
By default, an LLC is taxed as a pass-through entity. So when you create an LLC it will be taxed as a pass-through entity unless you elect otherwise by filing a form with the IRS.
Why would I elect for my “pass-through” entity to be taxed as another “pass-through” entity?
That’s a good question, and one I often hear from clients. One primary reason for an LLC to elect to be taxed as an S corporation is because LLC owners cannot be classified as employees unless the entity is taxed as an S corporation. If the LLC elects to be taxed as an S corporation, the owners can be employees of the LLC and can take salaries as “W-2 employees” and be subject to standard federal and state withholding taxes. Depending on the individual financial circumstances of each owner of your LLC, electing to be an employee versus strictly an owner (and having to pay self-employment taxes) can have a significant tax impact.
Notably, there are situations where forming a corporation makes more sense than an LLC, and where being taxed as a C corporation is a better route than being taxed as an S corporation. One particular instance is if you are raising money from investors because investors prefer the C corporation to the S corporation in terms of tax consequences.
LLCs Taxed as S Corporations versus Corporations taxed as S Corporations
The LLC offers a more flexible entity structure versus forming and operating a corporation. When running a corporation, there are additional corporate formalities that are required in order to maintain the limited liability protection. For example, corporations are required to hold annual shareholder meetings and elect a board of directors to oversee the higher level decisions made by the company and its officers.
LLCs offer the same level of limited liability protection without the additional administrative burdens of operating a corporation. Further, LLCs offer the ability to structure virtually all aspects of the company exactly how the owners want in the operating agreement. So at an entity level, an LLC will allow you more flexibility to operate and manage the business.
S Corporation Restrictions
If you fail to comply with the following restrictions, then your small business cannot be taxed as an S corporation:
- The entity must be a domestic company (formed in the U.S.);
- The entity can only have the following shareholders: individuals, certain trusts, and estates and may not include partnerships, corporations or non-resident shareholders;
- There is a cap of 100 total shareholders; and
- The entity can only have one class of stock.
Talk with a Tax Expert Before Making a Decision
Before you decide how to structure your small business, it is important to discuss your objectives with a tax expert. Your CPA, accountant, or tax attorney can help you determine which tax election will be most advantageous for you given your individual goals and circumstances.
If you have any questions about forming your company or deciding on the best entity structure for your new venture, please contact me or comment below.
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