S Corporations and LLCs: What You Need to Know

Most business owners are familiar with the various types of business structures: Sole Proprietorships, Partnerships, LLCs and S Corporations. But they may not be familiar with the different types of tax provisions they entail.

This is especially true of the S Corporation, which is not a business entity type at all but rather a special tax status offered by the IRS to some businesses, including Limited Liability Companies (LLCs).

For LLCs interested in electing S Corp status, it’s important to act fast. The deadline for this tax year is March 17. 

What is an LLC? 

LLCs are simple business entities in which the business’s profits flow to the owner’s personal tax returns. Known as pass-through entities, LLCs offer personal liability protection incurred through the business, which is one reason they are a popular business type.  

By default, LLCs are taxed as either Sole Proprietorships (if they have one owner) or Partnerships (if they have more than one owner). Under this model, all profits are taxed as income and the owner is required to pay self-employment tax, including Medicare and Social Security, on this amount.  

Enter: The S Corporation 

LLCs may elect S Corporation status from the IRS. Under this structure, profits paid as distributions to owners pass through to their personal tax returns, but they are not subject to self-employment taxes (Social Security and Medicare). They are, however, subject to income tax.  

It should be noted that an S Corporation isn’t a separate type of entity; rather, it is an optional election offered by the IRS. Because the S Corporation model is for tax purposes only, LLCs following this model continue to have the same business compliance requirements as their underlying entity type.  

Advantages & disadvantages of S Corps for LLCs 

The main benefit of an LLC electing S Corp status is potential tax savings.

In an S Corporation model, owners who do substantial work are considered employees and must be on payroll. They receive compensation as any other employee would and the company must pay Social Security, Medicare and unemployment taxes on that amount. They can also take distributions through profit sharing.  

Owners, however, only pay Social Security and Medicare taxes on their wages and salaries from the business—not on distributions. Therefore, the S Corp can reduce its tax liability while still providing personal liability protection. 

The downside is that S Corp status entails more complex work in managing payroll.

In addition, some LLCs may try to reduce their personal tax obligations further by lowering their salary and increasing their distributions. This raises a red flag with the IRS, so it’s important to pay a reasonable salary to avoid scrutiny. 

Eligibility for S Corp status  

Not all business entities are eligible for S Corp tax treatment. Sole Proprietorships and Partnerships must first become LLCs or C Corporations in order to make this election. LLCs and Corporations must meet the following guidelines: 

• They must be a domestic company. 

• No more than 100 shareholders are allowed. 

• The entity must issue only one class of stock. 

• The owners must be individuals, trusts or estates. 

• Owners must be legal residents of the United States. 

• Shareholders cannot be partnerships or corporations. 

• The business cannot be an insurance company, domestic international sales organization, or certain types of financial institutions. 

How to elect S Corp status 

Typically, business owners elect S Corp status when they file their LLC registration paperwork upon their business’s founding. But they can also make the election after the fact. To do so, they use IRS Form 2553 (Election by a Small Business Corporation).  

Newly formed LLCs have two months and 15 days from their date of formation to file for S Corp status. Existing LLCs have two months and 15 days from the beginning of the tax year that the election is to go into effect. Friendly reminder: For this year, that date is March 17. 

Choose the status that’s right for you 

While S Corp status can lower personal tax obligations for most LLC owners, each case is unique and it may not be the right fit for every business. We encourage business owners to consult with their attorney or tax professional to determine which model will maximize both personal and professional finances.