Key Takeaways

  • Electing S corp taxation for an LLC can reduce self-employment taxes, but it introduces new limits and compliance issues.
  • One of the major llc taxed as s corp disadvantages is the IRS requirement to pay “reasonable compensation” to owners, which increases payroll complexity.
  • S corp election restricts ownership: only U.S. citizens or residents may hold shares, and there’s a 100-owner limit.
  • Certain tax benefits available to LLCs (like flexibility in profit/loss allocation) are lost when taxed as an S corp.
  • Administrative costs rise due to mandatory payroll filings, stricter recordkeeping, and potential IRS scrutiny.
  • Not every business saves money—if profits are modest, the costs of compliance may outweigh tax benefits.

S Corporations and Taxes

In recent years, the government has addressed the rules for S corporations by making them more while cleaning up abusive rules. Some of the changes include:

  • A set limit on how much passive income can be received.
  • Tightened the rules for ownership by an ESOP.
  • Simplified some rules and complicated others.

One area that remains problematic for the government is employment tax, which results in lost revenue from S corporations. This means that S corporation owners can set their wages at a low figure and avoid paying Medicare and Fica taxes on their income. Some politicians are referring to S corp status as being that of a "tax shelter."

The Ways and Means Committee is looking at making a change to how taxes are accessed on small, flow-through companies. One of the potential plans is subjecting S corp owners to employment tax on all profits earned.

The thought of this plan is that it would be more equitable due to the distribution of profits and guaranteed payments from a limited liability company (LLC) that is subject to employment tax. If the tax form is ever adopted by Congress, the plan would negatively impact the appeal of forming an S corp.

For a business concerned about liability issues, it is often advised that an LLC not be formed as a C corporation. This is because this business form offers a high level of asset protection. It also means that to address federal income tax issues in many cases, owners will select the status for sole proprietorship or partnership. With a move toward LLC legal status, it may result in a decrease of regular corporations electing S corporation formation.

Employment Tax and Compliance Burdens

While electing S corp taxation can lower self-employment taxes, it also creates significant compliance burdens. The IRS requires LLC members taxed as S corps to pay themselves a “reasonable salary,” which must be reported through payroll systems. This means businesses must handle payroll taxes, withholdings, and quarterly filings—tasks not required for a standard LLC. Failure to pay a reasonable salary risks IRS audits and reclassification of distributions as wages. Additionally, administrative costs increase due to bookkeeping, legal fees, and accounting oversight.

About Limited Liability Companies

By default, an LLC is a partnership tax entity that can elect to be taxed as an S corporation or a C corporation and be subject to double taxation. A single-member LLC by default is taxed as a sole proprietorship and can elect to be either an S corporation or C corporation tax entity.

Disadvantages

Most LLC member earnings are subject to self-employment tax. With an S corporation, after salaries have been paid to shareholders working in the LLC, the remaining earnings can be passed through as distributions of profits. These funds are not subject to self-employment taxes.

Limited liability companies are considered a partnership for tax purposes. In the event 50 percent or more of the LLCs capital and profit interests are either exchanged or sold within a 12-month period, the LLC will terminate. If 35 percent or more of the losses can be allocated to non-managers, the cash method of accounting may no longer be an option.

LLCs treated as a partnership can't do several things. These include:

  • Incentive stock options aren't an option.
  • They can't take part in tax-free organizations.
  • Section 1244 stock can't be issued.

An S corporation can have one shareholder whereas an LLC must have at least two members to be treated as a partnership. Some states don't tax partnerships but do tax limited liability companies.

It should be noted that the statutes for LLCs lack uniformity, which could result in businesses operating in multiple states not receiving the same or consistent treatment.

While single-member LLCs are allowed in all states, the business can't elect partnership classification for federal tax purposes and must file a Schedule C as a sole proprietor.

Loss of LLC Flexibility

One of the advantages of an LLC is flexibility in allocating profits and losses among members. However, when an LLC elects S corporation status, this flexibility disappears. S corps must follow strict rules: ownership percentages determine distributions, and profits cannot be allocated disproportionately. This rigidity can disadvantage multi-member LLCs that want to tailor allocations based on investment or management contributions.

Another drawback is ownership restrictions. Unlike LLCs, S corps cannot have foreign owners, certain types of trusts, or more than 100 shareholders. These rules limit growth opportunities and investment options that LLCs might otherwise enjoy.

About S Corporations and Filing Taxes

Shareholders of a corporation must be citizens of the United States or have U.S. residency status. If shares are transferred or sold to a foreign national, S corporation status is terminated and the company is treated as a C corporation. If an S corporation loses its status for any reason, its owners/shareholders must wait a minimum of five years before being eligible to re-elect S corporation status.

Owners who want to take advantage of the limited liability that goes along with a corporation and the "pass-through" tax treatment available with a partnership often choose S corporation status. An S corporation must report its annual income to the IRS each year, filing Form 1120.

Practical Disadvantages of LLCs Taxed as S Corps

Beyond tax savings, there are several practical disadvantages to electing S corp status for an LLC:

  • Increased administrative complexity – Payroll setup, annual tax filings (Form 1120-S), and Schedule K-1 preparation raise costs compared to a default LLC structure.
  • Limited fringe benefits – Owner-employees holding more than 2% equity cannot deduct many employee benefits such as health insurance premiums on a pre-tax basis.
  • Risk of losing S corp status – If ownership rules are violated, the LLC reverts to C corp taxation, exposing it to double taxation.
  • Potentially minimal savings – Businesses with lower profits may find that the compliance costs exceed any self-employment tax benefits.

For many small businesses, these drawbacks make the S corp election less attractive than it initially appears. Careful tax projections should be run before making the decision.

Frequently Asked Questions

  1. Why would an LLC choose S corp taxation despite the disadvantages?
    To reduce self-employment taxes, especially when the business earns more than what would be considered a “reasonable salary.”
  2. What is the biggest disadvantage of LLC taxed as S corp?
    The biggest drawback is the added complexity of payroll and compliance requirements, which often increase costs.
  3. Can foreign owners participate in an LLC taxed as an S corp?
    No. S corp rules prohibit nonresident aliens from being shareholders, which restricts ownership opportunities.
  4. Does S corp election eliminate self-employment taxes entirely?
    No. Owners must still pay self-employment taxes on their salaries. Only distributions beyond reasonable compensation avoid these taxes.
  5. When does it make sense for an LLC to avoid S corp status?
    When profits are modest, ownership is diverse, or flexibility in allocating earnings is important, remaining a default LLC structure may be better.

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