You may have already formed your business as an LLC. Or, you might be considering forming an LLC because it helps you and any partners avoid potential personal legal liability while avoiding the double taxation that is levied upon C corporations. But, there is an additional tax savings opportunity that many LLC owners aren’t are of: LLC owners can elect to file the business’s taxes as an S-Corporation.
As tax time fast approaches, it might help to know that your LLC has the option of taking advantage of many benefits that some corporations enjoy at tax time. The choice is not necessarily right for every LLC, but here is a general primer that can help familiarize you with some concepts behind this decision.
Please understand that the purpose of this article is to help make you aware of a possibly-valuable tax technique. It is not intended to provide the advice that only your accountant or tax advisor can offer based on your company’s specific circumstances.
LLCs Versus Corporations: What’s The Difference to Your Taxes?
When you form an LLC, your company by default is considered a sole proprietorship for federal tax purposes if you are the only owner, or a partnership if two or more people own the company.
You probably already know the advantages from operations and liability standpoints. From a tax standpoint, however, LLCs filing as sole proprietorships or partnerships require the LLC owners to pay personal income tax, self-employment tax, estimated tax and more on the entire amount of the business’ profits, even if that amount exceeds a reasonable salary for the owners’ work on the business.
The good news is that it is possible to remain an LLC while filing taxes as an S‑Corporation, which will limit some of your employment tax obligations.
Why Filing Taxes as an S-Corporation Can Make Sense
When LLCs file taxes as S-Corporations, they can get the best of both worlds- the simplicity of the LLC and the tax benefits of S-Corporations- depending on their unique circumstances. Here are some things to consider when making the decision of whether to file your LLCs taxes as an S-Corporation
- Federal tax obligations always pass through to the members of any business. For sole proprietorships, partnerships and S-Corporations, the IRS passes total net profits through to the appropriate members to determine tax obligations.
- Income requirements are different, based on IRS requirements. LLC members receive guaranteed payments, rather than salaries for the work they do. When members of S-Corporations file taxes, they are seen as receiving salaries for their work at a rate comparable to what a regular employee doing that job would be paid.
- Federal taxes are based on income, received or not. Whether you file federal taxes as a sole proprietorship, partnership or S-Corporation, your taxes are based on the total net profits that flow from the entity — even if you do not distribute all of the net profit money that is allocated to you.
- LLC Owners can potentially lower personal tax obligations, if their company files taxes as an S-Corporation. Naturally, every income earner must pay personal taxes for income. However, at tax time, LLC members must pay self-employment tax (often known as payroll tax or FICA) for all of the business’ profit (distributed to each member based on how the profit or loss is allocated by their business agreement) on their personal returns. When LLCs file taxes as S-Corporations, the members see a FICA deduction on their paychecks during the year just like any employee, but they do not pay self-employment obligations on the profits of the business.
Payroll tax considerations are most likely the greatest benefit for members of LLCs that file taxes as S-Corporations. The difference between payroll tax obligations and FICA paycheck deductions can be significant.
Why Filing as a Partnership or Sole Proprietorship Might be the Right Choice
Filing taxes as an S-Corporation offers potential benefits to business owners, but you need to understand that unique financial or other circumstances can affect this choice, particularly as it pertains to partnership members.
One of the most common reasons an LLC should not file taxes as an S-Corporation is because LLC’s that file as S-Corporations are governed by a much stricter set of federal rules that could potentially cause them to lose S-Corporation status and be re-designated as C-Corporations, subjecting them to significantly more taxes and regulations.
One of these rules states that LLC’s filing as S-Corporations may not be owned by anything other than an individual. For example, if you want to raise money for your LLC, this rule disallows any of your investors from investing through a business entity they may own (like another LLC); they may only invest as an individual. LLC’s filing as S-Corporations also have a limit on the number owners.
Another potential issue is that LLCs do not necessarily allocate profits and losses in equal percentages among members. If you happen to be a member who receives allocations of 10 percent of net profits and 40 percent of net losses, for example, filing as a partnership allows you to take that 40 percent as a write-off while claiming only 10 percent of the business’ profits as income. If you file taxes as an S-Corporation, you now must take the same percentage of income as you take for losses.
Before making the election to file taxes as an S-Corporation, always consult a trusted tax advisor who has a detailed understanding of business finances, state tax rules and other issues.
How To File as an S-Corporation
There are relatively few basic steps involved in filing an S-Corporation election for tax purposes:
- File Form 2553, Election by a Small Business Corporation. Businesses choosing to file as S-Corporations must file this form prior to the first 2 months and 15 days of the beginning of the effective tax year. Your tax advisor can tell you if you also need to file Form 8832.
- File Form 8832, Entity Classification Election. While this form applies for corporation status, it is not generally required for businesses applying specifically for S-Corporation status. If you choose to use form 8832, you must file no more than 75 days prior to the date that the election is to take place.
- Make sure that the IRS accepts the election. Without written acceptance of the S-Corporation status by the IRS, the election is not effective. This can lead to significant issues with your tax filing. If the IRS rejects your election, it will explain the objections so you can correct them.
If these steps seem relatively simple, don’t be fooled. Another reason why your tax advisor should handle the filing is to help ensure that the forms are completed correctly and within the right time frame to reduce the possibility of an IRS rejection of your election. Just as important, if you miss the Form 2553 filing deadline, tax professionals often have magical (and legal) methods to request the IRS to retroactively accept your S-Corporation status when they receive your tax return.
This is Not Typically a Do-it-Yourself Project
On the surface, applying for S-Corporation status for tax purposes seems relatively straightforward. Now that you understand a bit more about the underlying concepts, however, you probably recognize that making the decision and handling the paperwork are not necessarily simple.
You should also understand that once your LLC files federal taxes as an S-Corporation, changing back to traditional sole proprietorship or partnership tax returns can be extremely challenging. The importance of enlisting expert advice from a local tax advisor cannot be overstated.