One of the more recent trends in the practice of CPAs structuring entities is the idea of forming a limited liability company (LLC) under state law and then making an election under Federal tax rules to have the entity taxed as a “small business corporation”, more commonly called a “S Corporation” or “S Corp.” The main reason for making the S Corp election is so that the part of the profits of the company can be treated as the profit of the company rather than wages to the owner. Unlike wages, S Corp profits are not subject to self-employment taxes, which are 15.3% (WOW!) and usually make up a large part of the owners overall federal tax liability.
There are pros and cons to consider if you are thinking about electing S corporation tax treatment for your LLC. One the one hand, you get the benefit of having only your wages subject to self-employment taxes if the LLC is taxed as an S corporation. On the other hand, your LLC must also comply with all of the ownership rules applicable to S corporation, which include a lot of tedious record-keeping and checklists to maintain compliance. Those rules also include the requirement of a single class ownership, no non-resident alien members, and no corporations or partnerships as members. Also, as a separate entity, the S Corp must comply with all withholding and reporting requirements of an employer, a task that wasn’t necessary if the LLC had no employees other than its members.
So, the obvious question: If you want your business to be taxed as an S corporation, why not just use a corporation rather than a limited liability company? Answer: The principal benefit of using an LLC rather than a corporation is that an LLC is almost always more flexible entity under state law. Even though you need to comply with the rules applicable to S corporations with respect to ownership, the LLC still offers much more room to design the entity to your own specifications. Using an LLC allows you to eliminate many of the formalities that a corporation must observe to preserve its corporate status. With an LLC, you do not need a board of directors, meetings or minutes, for example.
To have your LLC receive the tax treatment of an S Corp, you must file an election with the IRS using both Form 8832 and 2553. You must file these forms within the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. If you file it later, your election will be effective for the next tax year.
In conclusion, if you have a business that generates a nice profit over and above what you would consider reasonable compensation for the services that the owners provide, you may be unnecessarily the profits to self-employment taxes if you are operating as an LLC taxed as a partnership. If you think your business may fit this model, your LLC may benefit from choosing to be treated as an S corporation under the tax laws.
Dan Lucas, CPA/ABV, Five Star Professional©
Managing Partner, Credo Financial Services