Popular Small Business Strategic Combo – LLC with an “S” election

It is a common strategy in the small business community to operate legally through a limited liability company (“LLC”) and filing an election (IRS Form 2553) to have the LLC classified for tax purposes as an S corporation.  The LLC is often an optimal choice of entity for a small business because of the limited liability protection to owners, minimal entity maintenance requirements an formalities, and tremendous flexibility the LLC offers in terms of structuring the ownership, governance, and economics of the business.

But why elect S corporation tax status?  By default, the IRS classifies a single-member LLC as a sole proprietorship for tax purposes and a multi-member LLC as a partnership.  The most commonly cited reason for the decision to elect S corporation status is to allow a business owner who is actively involved in the business to reduce self-employment taxes while the company continues to enjoy the benefits of pass-through taxation.  Whereas a sole proprietor or a partner in a partnership who is actively involved in the business is considered a self-employed individual and, therefore, subject to the federal self-employment tax (which amounts to approximately 15% of the owner’s share of business profits), an owner of an LLC classified for tax purposes as an S corporation is NOT considered a self-employed individual and, therefore, is not subject to the self-employment tax.  In other words, upon filing the S election, the owner magically transforms from being considered a self-employed individual to a W-2 employee.  As an employee, you and your accountant decide on a reasonable salary to pay yourself, and from that salary the usual federal and state payroll taxes will be withheld each pay period.

The benefit to the owner arises because the owner’s allocable share of profits (i.e., over and above what you pay yourself as salary), if any, can be taken as a dividend or profit distribution, and is not subject to any employment-related taxes.  By contrast, all profit from an LLC classified as either a sole proprietorship (single-member LLC) or a partnership (multi-member LLC) is subject to self-employment tax with respect to an owner who is actively involved in the business.

Still, there are issues to consider that might deter a business owner from making an S election.  From a legal perspective, there are several eligibility requirements for S corporations that limit the number (and type) of owners and limit the company to one class of equity.  Converting to an S corporation may also give rise to additional expenses for payroll service and tax preparation fees (S corporations must file annual corporate tax returns even though an S corporation is a pass-through entity).  As with most business decisions, there are pros and cons to assess with your legal and tax advisors before making a final decision.

In sum, if you are an active owner of an LLC, you can potentially save some meaningful tax dollars by electing S corporation status.  It is a topic certainly worth discussing with your accountant and business attorney.