Key Takeaways

  • An LLC can elect to be taxed as an S Corporation to combine liability protection with tax efficiency.
  • LLCs offer operational flexibility and pass-through taxation, while S Corps offer potential self-employment tax savings.
  • LLC S Corp status is especially useful for profitable businesses with stable income and owner-employees.
  • S Corp election comes with IRS requirements like reasonable compensation and strict ownership rules.
  • S Corps must meet IRS eligibility guidelines and adhere to more formal compliance measures than LLCs.
  • Filing Form 2553 is necessary to gain S Corp tax treatment for an LLC.
  • It's important to understand potential drawbacks like limited stock classes and increased administrative duties.
  • Seek legal and tax advice—an attorney from UpCounsel can help you decide if an LLC S Corp election is right for you.

Forming an LLC S corp is a good choice for companies that want to reap the benefits of both types of organizational forms. Before deciding if an LLC with an S corporation status is right for your business, find out everything you need to know about both LLCs and S corporations. 

Comparing LLC vs. S Corporation

Limited liability companies and S corporations are two of the most popular kinds of organizational forms today. It's common for business owners, accountants, and lawyers to get caught up weighing the pros and cons of each option. However, it's not necessary to choose one over the other. Instead, you can set up your company as an LLC and then elect to have it treated as an S corporation. 

If you're starting a new business or thinking of changing the status of an existing business, you'll want to compare LLC vs. S corporation features and benefits. Both organizational forms have many things in common. There are also many things that make each one unique. It's important to take a close look at each one before you decide the best fit for your company.

Key Differences in Taxation and Ownership

Although both LLCs and S Corporations offer pass-through taxation, the way income is reported and taxed differs. LLC members generally pay self-employment taxes on all business profits. In contrast, S Corp owners can pay themselves a salary and take additional profits as distributions, which are not subject to self-employment taxes.

Ownership rules also vary significantly:

  • LLCs can have unlimited members, including individuals, corporations, or foreign entities.
  • S Corporations are limited to 100 shareholders, and all must be U.S. citizens or residents.
  • LLCs can have different classes of ownership and profit-sharing arrangements, while S Corps must have only one class of stock.

These distinctions make S Corps a better fit for some businesses, especially those with stable income and fewer owners who actively participate in the business.

What Is an LLC?

An LLC offers the same limited liability benefits of a corporation. It also has the same flexibility in terms of operations as a sole proprietorship and general partnership. 

For federal tax purposes, an LLC with one owner is treated the same as a sole proprietorship. As such, it is a disregarded entity, and the owner pays income tax on his or her personal tax return. An LLC with more than one owner is taxed as a partnership. In such a case, the owner is not considered an employee of the company for tax purposes.

The main benefits of an LLC include:

  • Avoiding double taxation by passing income on to owners to pay on their personal income tax.
  • Having more flexible operations with fewer filings and forms, lower start-up costs, and less-formal meeting and record-keeping requirements.
  • Being able to distribute company earnings as the owners want and not based on the percentage of capital contributions.
  • Passing the company's net earnings to owners as self-employment income that is taxed at 15.3 percent to cover their Social Security, Medicare, and Old Age Survivors and Disability Insurance (OASDI) costs.

When to Choose an LLC Over an S Corp

Choosing an LLC without electing S Corp status may be beneficial if:

  • You expect business losses in the early years and want them to flow directly to your personal return.
  • You plan to reinvest most of your profits back into the business.
  • You prefer flexible management structures and fewer compliance obligations.
  • You anticipate bringing in new members or foreign investors, which are prohibited in S Corps.

LLCs also make it easier to change your tax status later as your business grows or stabilizes.

Becoming a Corporation

An LLC can choose either a traditional C corporation or an S corporation tax status. To do so, the LLC must first become a corporation by filing Form 8832, Entity Classification Election. 

There are several sections to the form. The first section helps you figure out if your business is eligible to change its status. In the next section, you need to state your current business type and select the type of entity you want your business to become. 

The last section includes a consent statement. All owners need to sign their consent or appoint one member to sign on behalf of all the company's owners. If the company opts to have one owner sign the form, the business should have a record that all members agreed to allow this person to sign on their behalf. This record could include minutes from company meetings, for example. 

Steps to Elect S Corporation Status as an LLC

To elect S Corp status, an LLC must follow these steps:

  1. Ensure eligibility: The LLC must meet the IRS's requirements for S Corporations (e.g., number of shareholders, type of shareholders, domestic incorporation).
  2. File Form 2553: Submit IRS Form 2553, Election by a Small Business Corporation, signed by all members.
  3. Maintain formalities: Once approved, the LLC must comply with S Corp rules, such as issuing W-2s to owners who work in the business and ensuring reasonable compensation.
  4. Adjust accounting systems: You may need payroll systems and formal financial recordkeeping to meet IRS scrutiny.

S Corp status is not automatic—it requires careful planning and may not be the right fit for all LLCs.

What Is an S Corporation?

To become an S corporation, you must file Form 2553 with the Internal Revenue Service (IRS). Choosing S status allows you to avoid double taxation by passing corporate income, losses, deductions, and credits to shareholders for federal tax purposes. 

In order to qualify for S status, your company is subject to certain limitations. If these limitations do not interfere with your business operations, an S corporation status may be a good fit for your LLC. To elect an S status, your company must meet the following requirements:

  • It must be a U.S. corporation.
  • It cannot have more than 100 shareholders.
  • Shareholders cannot include partnerships, corporations, or nonresident aliens.
  • It must have only one class of stock, which can include both voting and nonvoting stock.
  • It cannot include certain types of financial institutions, insurance companies, and domestic international sales corporations.

There are many advantages to setting up an LLC S corp. Before deciding if it's the best fit for your business, be sure you learn everything you need to know about both LLC and S corporations.

Benefits and Drawbacks of LLC S Corp Election

Benefits of electing S Corp status as an LLC:

  • Reduced self-employment taxes: Owner-employees only pay payroll taxes on their salary, not on the remaining profits.
  • Pass-through taxation: Profits and losses still flow through to individual returns, avoiding double taxation.
  • Credibility and structure: Operating as an S Corp may enhance professional credibility and make it easier to raise capital from individual investors.

Potential drawbacks:

  • Stricter compliance: Requirements such as issuing stock, adopting bylaws, and holding formal meetings increase administrative overhead.
  • Reasonable salary rule: The IRS mandates that owner-employees pay themselves a "reasonable" salary, which must be substantiated and documented.
  • Eligibility restrictions: You can't have foreign shareholders or more than 100 owners, and you must have only one class of stock.

Before making the election, consult with a legal or tax advisor to determine if the long-term benefits outweigh the added responsibilities.

Frequently Asked Questions

1. Can a single-member LLC elect S Corp status? Yes, a single-member LLC can elect to be taxed as an S Corporation by filing IRS Form 2553, provided it meets eligibility criteria.

2. What is considered a “reasonable salary” for S Corp owners? A reasonable salary is based on industry standards, experience, duties, and time spent working. It should be comparable to what similar employees earn in similar roles.

3. Can I switch from LLC taxation to S Corp status later? Yes, you can file IRS Form 2553 at a later date, typically by March 15 of the tax year you want the election to take effect.

4. What are the compliance requirements for an S Corporation? S Corps must follow corporate formalities like issuing stock, maintaining meeting minutes, and filing payroll taxes for employees, including owners.

5. Do I need to dissolve my LLC to become an S Corp? No, you do not need to dissolve the LLC. You simply elect S Corp status for tax purposes while maintaining the LLC as your legal structure.

If you need help with LLC S corp, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.