Key Takeaways

  • An LLC taxed as an S Corp can reduce self-employment taxes by allowing owners to take a salary and receive remaining profits as distributions.
  • You must file IRS Form 2553 and meet specific eligibility requirements to elect S Corp status.
  • An S Corp election benefits LLCs with consistent and higher profits due to potential employment tax savings.
  • LLCs taxed as S Corps must ensure reasonable compensation is paid to owner-employees to comply with IRS requirements.
  • There are additional compliance requirements, such as running payroll, filing quarterly taxes, and maintaining good records.
  • Single-member and multi-member LLCs can elect S Corp status if they meet the IRS's ownership and structure criteria.
  • Timing is crucial: Late filings may still qualify under IRS relief provisions.

LLC Taxed as S Corp

What is an LLC taxed as an S Corp? It is a one-owner LLC, which is treated as a sole proprietorship. Multi-owner LLC’s receive the same tax treatment as a partnership. Once the LLC is formed, choosing how your business is to be taxed is performed by filing an election document (Form 2553) with the IRS. You can choose to be taxed as a C corporation or as an S corporation. Although many LLC’s choose to go with the default tax format, there are some tax benefits available if you choose the S Corporation.

An LLC taxed as S Corp enjoys more tax benefits than just an LLC. State laws recognize a limited liability company, or LLC, as a legal entity for the purpose of running a business. A strong advantage of using this business form is that it gives that business similar advantages that a corporation has, but it is easier to create and operate.

How S Corporations Are Taxed

In an S Corporation, the taxes flow through it to the individuals who own it and the income or losses are reported on their tax forms. The taxes are reported in the same way that a partnership does. On the tax Form 1120S, the details of the business’s finances are reported, including:

  • Income
  • Deductions
  • Profit
  • Losses
  • Tax credits

A Schedule K-1 must also be submitted to all shareholders, which shows the portion of money received that were reported on the 1120S. Each shareholder reports their share on a Schedule E when they file their 1040 taxes. Owners of an S Corporation can benefit from this format, more than would be possible by using the C organization format for their LLC. In a regular LLC, owners who are partners are not considered employees.

When an owner who actively participates in the business performs services for an LLC that is taxed as an S Corporation, it is necessary to be treated as an employee for tax purposes and as an owner. Average pay or salary must be given for those tasks performed, and the same benefits need to be given that other employees receive. The dual status of an owner is how greater tax benefits are given. The salary given for services performed is taxable, and must be reported on 1040 taxes. Social Security and Medicare Taxes will also have to be taken out of this income, as well as any Federal and state taxes that apply.

Because taxes on income received as an employee will be the same as that of any other employee, owners will not receive any tax benefit on this portion of their income. In fact, even though you are the owner of the business, you will be paying both your share and the business’s share. Other employees will only pay half, and the business will pay the other half.

The primary benefit of an S Corporation is from the shares received. This money is not subject to employment taxes in the same way that your regular income is taxed. This means your business can keep more money in the business, enabling you to keep more of the profit. The more money that is paid out in shares to yourself and to your employees, the more money you save.

The S Corporation is the only business form that lets you save on employment taxes. The ability to save money makes it popular among professionals who expect to make considerable profit.

Risks of Improper S Corp Election or Operation

Electing S Corp status without meeting the ongoing requirements can expose an LLC to penalties and back taxes. Common risks include:

  • Misclassifying Owner Compensation: Paying too little salary can trigger IRS audits.
  • Violating Ownership Rules: Having ineligible shareholders (e.g., foreign individuals or corporations) disqualifies the S Corp election.
  • Multiple Stock Classes: Unequal distribution rights or preferences in profit distribution can lead to disqualification.

Staying compliant requires clear operating agreements, consistent distributions, and timely tax filings. An experienced business attorney can help ensure proper setup and maintenance.

How to Elect S Corporation Status

In order to obtain the S Corporation benefits, they need to be applied for after the Corporation has been formed, using IRS Form 2553. A LLC has 75 days to make the application.

Other businesses that already exist can elect to change their business form to an S Corporation for tax purposes at the start of each year. Certain criteria will have to be met in order to be accepted under this status, and there are some rather strict rules that must be applied to continue to qualify. The qualifications include the following:

  • There are no more than 100 shareholders.
  • All shareholders must be U.S. citizens – no non-resident aliens allowed.
  • Only one class of stock is permitted; all shareholders must receive the same benefits.
  • Other corporations or partnerships cannot be shareholders, but some estates, trusts, and exempt organizations may be permitted.

Timing Your S Corporation Election

To be treated as an S Corporation for a given tax year, your LLC must file Form 2553 no later than two months and 15 days after the beginning of that tax year. For newly formed LLCs, the election is due within 75 days of the entity’s formation date. Missing this deadline doesn’t necessarily disqualify you, however—the IRS offers late election relief under specific criteria, especially if the entity can show reasonable cause for the delay and has acted in good faith.

LLC and S Corporations: Key Similarities

Accountants like LLC’s and S Corporations because the taxes are passed through the corporation. The corporations do not pay taxes on the profits made each year. Instead, they are passed through the corporation to the owners and employees and are reported on the individual’s tax returns. In addition, the LLC’s and S Corporation forms enable the owners to be separated from the business and it also provides liability protection.

LLC and S Corporations: Key Differences

Between the two forms of corporation, it is easier to run an LLC. The LLC has fewer requirements for paperwork for the state, fewer meetings are required, and it also has lower start-up costs. This provides an advantage for smaller businesses because:

  • It eliminates the extra paperwork that a C or S Corporation requires.
  • It enables owners to disperse profits and losses in more ways. Owners can divide profits with greater flexibility, letting each owner be taxed accordingly.
  • Owners are taxed according to their ownership percentage.
  • Owners can disperse part of the profit through wages or salaries, and the rest through distributions. Only the wages or salaries earned are available to be taxed under Social Security and Medicare in an S Corporation.

Considerations for Freelancers and Solo Entrepreneurs

Freelancers and solopreneurs often start as single-member LLCs. While the default tax treatment is as a sole proprietorship, electing S Corp status can yield significant savings once income levels rise. However, it's crucial to weigh:

  • Administrative Overhead: You'll need to manage payroll and handle more complex tax filings.
  • Reasonable Salary Requirement: The IRS scrutinizes low salaries with high distributions.
  • Health Insurance: Owner-employees must include the cost of health insurance premiums in their W-2 wages.

For many freelancers making consistent income beyond $60,000 annually, the savings can justify the added complexity.

Combining the LLC and S Corporation

Small business owners can choose to set up their business as an LLC and then opt to file taxes as an S Corporation. Legally, your company is an LLC. To the IRS, however, your business is an S Corporation. This combination gives you the advantages of less state filings, less paperwork, and lower costs overall. You also get the benefit of being able to distribute some of your profit as non-taxable distributions, rather than as salary or wages. Prior to electing for an S corporation status, it is necessary to obtain an EIN (Federal Tax ID Number).

Ongoing Compliance Requirements for LLCs Taxed as S Corps

Once you elect to have your LLC taxed as an S Corporation, there are several ongoing obligations to remain compliant with IRS rules and maintain your tax advantages:

  • Payroll Setup: You must pay owner-employees a reasonable salary through payroll, which includes withholding and remitting employment taxes.
  • Quarterly Estimated Taxes: S Corps must file and pay estimated taxes each quarter, including federal and possibly state obligations.
  • Separate Tax Filings: The business must file Form 1120S annually and issue Schedule K-1s to all shareholders.
  • Corporate Formalities: While not as extensive as a traditional C Corporation, you’ll need to maintain basic corporate formalities such as recording shareholder meetings and documenting major decisions.

Electing S Status for a Corporate Entity Under the Check-the-Box Rules

If desired, it is possible for an LLC to become a corporation under the IRS’s check-the-box rules. If it elects to do so, it must transfer all assets and any liabilities to the new corporation. This is in exchange for the stock, which is then distributed among the owners for complete liquidation.

No taxes are charged for the process, as long as Sec. 351(a) applies, and as long as the liabilities are not greater than the assets. Once this is completed, the corporation can select the S status, as long as each member meets the requirements. Normally, the corporation would file Form 8832, Entity Classification Election, which is in accordance with Regs. Sec. 301.7701-3(c). Eligible corporations that file for an S election (Form 2553) on time will be taxed as a corporation (Regs. Sec. 301.7701-3(c)(1)(v)(C)). Form 8832 does not need to be filed as long as the requirements for S status are met.

The election for S Corporation status on Form 8832 cannot be greater than 75 days before the election date, and it cannot be more than 12 months after the filing, according to Regs. Sec. 301.7701-3(c). The classification may be valid for 75 days prior to the filing of Form 8832.

New corporations are required to file the S Corporation election papers by the 15th day of the third month after it becomes active. Only after that date can the corporation obtain shareholders or assets, and begin conducting business according to S Corporation Rules.

When an organization chooses to become a corporation and an S Corporation at the same time, it only needs to file Form 2553 and then begin to follow the rules for S Corporations. It is not necessary to begin operating as both at the start of a new year.

How the Check-the-Box Rules Impact Tax Classification

The IRS’s check-the-box rules allow eligible entities to choose their classification for federal tax purposes. A default single-member LLC is disregarded as a separate entity, while a multi-member LLC is treated as a partnership. Using Form 8832, the LLC can elect to be treated as a corporation, and then use Form 2553 to choose S Corporation status.

This two-step process is essential for LLCs that initially want corporate treatment or need to correct an overlooked classification.

Relief for Missed S Corporation Elections

If a corporation misses the deadline for elections that are S Corporation related, the IRS has made provisions for relief in Rev. Proc. 2013-30. This provision includes electing to be considered as an S Corporation according to Sec. 1362(a), and as a corporation according to Regs. Sec. 301.7701-3(c)(1)(v)(C), which enables it to be treated as an S Corporation.

Electing S Status by LLC Treated as Partnership

Partnerships that are eligible to be treated as a corporation, or one that changes into one under a state-law conversion statue, is treated as if it transferred all of its assets and liabilities to the corporation in exchange for stock. It is also considered to have eliminated all its assets through the distribution of them to its partners immediately prior to the day that its election becomes active. Partners may want to take advantage of incorporation in order to provide personal liability protection and to ensure that there will be continuity of the business. If the business elects to operate under S Corporation Rules, gains and losses can be passed on to the owners for tax benefits.

Potential One-Class-of-Stock Issues

When a business elects to operate under S Corporation Rules, it must ensure that its documents under which it operates meets the requirements and will conform to the Rules. If there are any documents or practices that treat it as a partnership, these will need to be eliminated or amended to conform. Any documents that allow for the distribution of stock in a way other than based on percentage of ownership is a breach of the rules and is not permitted in an S Corporation. All shareholders must be in the same class, with the only difference being that of holding voting or non-voting shares.

One exception to this rule is when an LLC is operating as a partnership. The operating document may specify that certain members are general partners and others are designated as limited partners. In this situation, the IRS has determined that the requirement for one-class-of-stock is not violated as long as all partners receive equal rights for distribution and liquidation.

For state-law limited partnerships that have checked-the-box to operate as a corporation, the IRS has announced that it is not going to issue an advance letter ruling that they have more than one class of stick, according to Rev. Proc. 2013-3, §5.01(18). Previously rulings, such as Rev. Proc. 2013-3, §5.01(18) and earlier versions, were unclear as to whether or not one-class-of-stock conforms. 

Can an LLC Be Taxed as S Corp? Reducing Taxes by Reducing Self-Employment Tax

An LLC is required to pay taxes at the standard self-employment rate of 15.3 percent, which is for Medicare and Social Security. An S Corporation employee, the owner, only needs to pay self-employment taxes on any income received from salaries or wages. Any other profits the S Corporation receives can be distributed free of the self-employment tax to its shareholders. The strongest benefit an S Corporation offers is that it enables a business to keep more of its profit by bypassing the self-employment taxes on its distributions. An important factor when determining the wages for a shareholder/employee is that they must be reasonable and comparable to current commercial wages. If this is not correct, the IRS will determine all profits to be wages, and the necessary taxes will be applied.

If large profits are not anticipated, but there are considerable assets, an LLC is a better instrument. When larger profits are anticipated that will be considerably greater than projected salaries, an S Corporation is better, as long as the business is willing to do the extra paperwork and hold more meetings. An LLC taxed as S Corp can save money if it files for an S Corp status, if it expects profits that are likely to be greater than the designated salary.

When Electing S Corp Status Makes Financial Sense

Electing S Corp tax status is not ideal for every LLC. It generally makes the most sense when the business consistently earns more in net profits than what the owner would take as a reasonable salary. A common rule of thumb is when net earnings exceed around $40,000 annually after deductible expenses, the tax savings from reduced self-employment taxes can outweigh the added administrative burden.

If your LLC has limited profit or fluctuating income, the costs of S Corp compliance—like payroll services, accounting, and additional tax filings—might cancel out potential savings.

Frequently Asked Questions

1. What is the primary benefit of having an LLC taxed as an S Corp? The main benefit is potential savings on self-employment taxes by splitting income between salary and distributions.

2. How do I elect S Corporation status for my LLC? You must file IRS Form 2553 within 75 days of formation or by March 15 of the tax year you want the status to begin.

3. What happens if I miss the S Corp election deadline? The IRS offers relief for late elections if you meet specific criteria, including reasonable cause and timely filing of all tax returns.

4. Can I change back from S Corp taxation to standard LLC taxation? Yes, but this requires filing with the IRS and may have tax implications. It’s advisable to consult a tax professional first.

5. Is an S Corp right for my small business or freelance work? If your net income consistently exceeds your reasonable salary, and you’re comfortable with the administrative work, it can be a tax-efficient choice.

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