LLC Subchapter S Election: Everything You Need to Know
For tax status, LLC subchapter S election is like having the best of both worlds for your business.3 min read
For tax status, LLC subchapter S election is like having the best of both worlds for your business. It may come as a surprise that you may freely choose which tax type your business entity should have, including corporation, partnership, and subchapter S corporation. Although the partnership option is popular, choosing Subchapter S status has many benefits. Both have pass-through tax treatment. Both the LLC and Subchapter S structures are not responsible for paying their own taxes. Profits pass on to the owners, who report the income on their own 1040 tax forms. Also, both separate the business from personal assets in terms of liability.
Differences Between LLCs and S Corporations
There are a few important differences between the two structures. LLCs are generally simpler to run. You'll need fewer meetings, less documentation, lower startup capital, and fewer state filings and forms. Many business owners appreciate this.
The LLC is also more flexible in how the profits and losses are distributed among the owners. In an LLC, even if two owners have the same percentage of ownership, they may elect to split the profits and losses according to how much time was spent running it. In an S corporation, each would automatically be taxed on 50 percent of the profits.
On the other hand, the S corporation offers more flexibility in how profits are distributed. With an LLC, profits are considered self-employment income, so the owners must pay self-employment tax. With an S corporation, earnings are considered wages and distributions. Deductions for Social Security and Medicare only apply to the wages, not the distributions. The only restriction is that owners must be paid a reasonable salary.
What most people are unaware of, however, is that an LLC can be set up so the IRS treats it as an S corporation. Although the business enjoys all the advantages of having an LLC, owners can receive some of the profits as distributions instead of salary, thereby avoiding taxes for Medicare and Social Security.
How S Corporation Tax Works
S corporations and LLCs are both pass-through entities, which means income and losses are passed along to the owners, who report it on their own taxes. S corporations need to file informational returns (Form 1120S) to report the business's profits, losses, deductions, and other details each year. Shareholders are provided with a Schedule K-1 with information on their shares of each of the above items. In turn, shareholders file Schedule E when paying their yearly taxes.
S corporation owners who work within the business are considered employees as well as owners. Therefore, they are paid a salary for their labor. Although the tax rate for Medicare and Social Security remains the same, it's paid in a different way. Half is paid by the employee and half by the employer. As an owner, you are paying the same amount, even though it's split.
Can Your LLC Elect S-Corp Status?
There are some restrictions on who can form an S corporation. You can elect S-corporation status if:
- The owners are U.S. citizens or residents with valid Social Security numbers
- You are the single member in an LLC, considered a disregarded entity
- There are two or more members in your LLC, considered a partnership
- You have an EIN (Federal Tax ID Number) for your LLC
- Your business is already formed as an LLC — it may not begin as an S corporation
- Your business has no more than 100 shareholders
- Your business has only one class of stock
- None of the company's shareholders are other partnerships or corporations
To elect an S-corporation taxation entity for your business, you must submit IRS Form 2553. This must take place no more than two months and 15 days after the tax year that you want this change to go into effect. Doing this on time eliminates a lot of paperwork normally required by a corporation. The effective date can be no more than 12 months after the date of filing.
Although pass-through entities are popular in the U.S., it's not necessarily the right choice for every business. Remember, if such an election is made, revisions to the company's operating agreement must take place, as well as adherence to all rules and regulations. If this is done improperly, the IRS may consider the company a C corporation instead.
If you need help with LLC subchapter S election, 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 our behalf of companies like Google, Menlo Ventures, and Airbnb.