Why LLCs Choose to be Treated as S Corporations for Tax Purposes
There’s one main reason that LLCs choose to file and pay taxes as an S Corporation — a reduction in the amount of self-employment (FICA, Social Security, and Medicare) tax that they need to pay. Here’s how it works.
Both LLCs and S Corps are “pass through” entities for tax purposes. This means any profits earned by the business are taxed on the owner’s filings. We’re defining profits as revenue minus expenses — in other words, the amount of money your business makes and pays to owners after all of your business costs are deducted.
For example, if an LLC has two owners and makes $150,000 in profits, that $150,000 is entered as earnings on the 1040 forms ($75,000 each), and tax is calculated on that amount.
Here’s where it gets interesting.
Standard LLCs and Paying Tax on Earnings
Almost all standard LLCs will pay three types of tax on all profits they earn:
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Self-employment tax on all profits earned, at 15.3%.
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Federal income tax on all profits earned after standard deductions and tax credits.
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State income tax on all profits earned after standard deductions and tax credits.
Note, this doesn’t include sales and use tax, property tax, or any other taxes a business or individual may need to pay.
For example, if our two LLC owners are a married couple, filing jointly in 2018 in New York state, their taxes would likely work out as follows:
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Earnings: $150,000
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Federal income tax due: $10,700
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Self-employment tax due: $21,200
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State income tax due: $7,900
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Total tax burden: $39,800
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Percentage of earnings paid as tax: 26.5%
LLCs Treated as S Corporations Paying Tax on Earnings
S Corporations allow LLCs to reduce the amount of self-employment / payroll tax that they pay. Essentially, an S Corporation will treat the LLC owners as employees and pay them a “reasonable” salary. The employer (the LLC) and the employee (owner) will each need to pay payroll tax, which is the functional equivalent of self-employment tax. The remainder of the profits in the business can be taken out as a “distribution,” and there’s no self-employment or payroll tax due on that amount.
This means you can take some money out of the business as salary, pay your payroll / self-employment tax as normal, and take the rest as distributions, which is still liable for the federal and state income taxes.
For example, let’s say our married couple takes $90,000 out of the business as a salary, and $60,000 as distributions — what does that do to their tax burden?
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Earnings: $150,000
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Taken as salary: $90,000
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Taken as distribution: $60,000
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Federal income tax due: $12,000
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Payroll tax due: $12,700
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State income tax due: $7,900
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Total tax burden: $32,600
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Percentage of earnings paid as tax: 21.7%
Filing as an S Corporation reduced this couple’s tax burden by 5% of their earnings, or just over $7,000. You might also notice that the federal income tax owed increased slightly. That’s because money paid as wages or salary is not “Qualified Business Income” that gets a 20% pass through discount from the Tax Cuts and Jobs Act. Additionally, there are a couple of other additional taxes and fees not included in this example — more on that below.
It’s important to note that filing as an S Corporation will not typically reduce taxes you pay elsewhere, for example, it won’t have a material impact on state taxes owed, sales and use tax, or other taxes.
When You Should Get Your LLC Treated as an S Corporation
In most cases, if your LLC is earning more than around $60,000 a year per owner after expenses, it makes sense to file as an S Corporation. Below those values, the extra costs and administrative overhead for running payroll, administration, taxes, and accounting fees may make it less worthwhile.
How to Get Your LLC Treated as an S Corporation for Tax Purposes
You need to file a Form 2553 with the IRS to have your LLC treated as an S Corporation. The form is known as “Form 2553, Election by a Small Business Corporation.” There are a few restrictions that may impact whether you’re accepted for filing as an S Corporation, but these are not too onerous.
Form 2553 must be filed no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect. For example, if you wanted to be treated as an S Corporation in 2019, and your tax year starts on 1 January, you’d need to file Form 2553 by the middle of March — if you filed later than that in 2019, you’d be an S Corporation for tax year 2020 onwards.
Reasonable Salaries for S Corporation Owners
You might be asking why an S Corporation owner wouldn’t just take a salary of $0, avoiding self employment / payroll tax altogether. The IRS are wise to this trick and take a very dim view, so instead they insist on all owners and officers paying themselves a “reasonable” salary.
If you don’t pay what they deem reasonable, they may audit your business and penalize you for not paying the right amount in salary, and the subsequent payroll tax that generates. Unfortunately, the IRS hasn't released official guidance on what a “reasonable salary” might be, but looking at court cases and applying common sense means we can make some reasonable inferences. For example, you could:
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Pay yourself a salary of at least half the profits that would be paid to you.
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Not take out more than half your profits in distributions (not liable to payroll / self-employment tax).
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If you can, going to a 60%/40% split between salary and distributions.
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Look at what other employed positions pay to someone in a similar role to you with a similar level of experience and pay that amount.
In all cases, we’d recommend talking to your accountant about their recommendations on where to set your salary level.
New Tax Regulations for an LLC Filing as an S Corporation
Here’s what changes from a tax perspective between filing as a “standard” LLC and filing as an LLC that’s treated as an S Corporation.
What You Won’t File as an S Corporation
Here are the forms you don’t need to file any more, once you’re accepted as an S Corporation:
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If you’re a sole proprietor LLC, you will no longer file a 1040 with attached schedule C (business income) and schedule SE (self-employment tax).
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It you’re an LLC with more than one member / owner, you will no longer file a 1065 partnership return.
What You Will File as an S Corporation
Both sole proprietors and partnerships must now:
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File a Form 1120S — US Income Tax Return for an S Corporation, with the IRS each year by March 15.
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File the appropriate S Corporation tax return with the state.
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Run payroll regularly according to state mandates, paying a reasonable salary.
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Withhold payroll, federal, and state tax for each pay period and pay it to the relevant agencies (state DOR and IRS) in good time.
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File a W2 salary report for each owner-employee, and regular employees each year, in January.
What You Will File as an S Corporation Owner
You will still need to file 1040 tax returns and estimated taxes:
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You will file a 1040 as normal each year where you will show both wage / salary income and distribution income, together with all the other income and credits that would normally be available.
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You should still calculate and pay estimated taxes on a quarterly basis., Note that if you’re withholding taxes on your payroll and paying those on a regular basis, you will only need to calculate and pay estimated taxes on your distribution and other, non-wage income.
The Drawbacks of Being an LLC Filing as an S Corporation
Although there are some significant tax advantages to filing as an S Corporation, there are some drawbacks as well, and it’s important to be aware of them.
Once You’ve Chosen to File as an S Corporation, You Must Continue to Do So
After you’ve made the Form 2553 election, you must file as an S Corporation from that point forward, unless you formally revoke the S Corporation election.
There Are Additional Costs for Filing as an S Corporation
LLCs filing as S Corporations are more complex to administer and file for, this means you can expect to pay some additional fees and taxes, for example:
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Fees for payroll software to run your payroll on a regular basis — anywhere from $40 upwards per month.
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Higher accounting fees for preparing and filing the 1120S, W2, and other forms.
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The requirement to pay a couple of special unemployment taxes, known as FUTA and SUTA.
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The need, in some cases, to pay additional franchise taxes.
This could easily add up to an additional $2,000 to $3,000 in taxes and fees per year, reducing the payroll tax savings.
Loss of 20% Discount on Qualified Business Income from the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act introduced a 20% discount on “Qualified Business Income” for determining how much owners of pass through entities owed in federal income taxes. For example, if you made a profit of $150,000, you’d pay federal income tax as if you’d earned $120,000.
Unfortunately, that discount does not apply to the money you pay yourself or others as a salary. This means your federal income tax owed on your salaried earnings will increase, although not nearly by as much as you will save on reduced payroll / self-employment taxes. You will still receive the 20% discount on the distributions you take out of the business.
Legal Requirements for an LLC Filing Taxes as an S Corporation
Don’t worry, we’re nearly at the end! It’s worth spending a little while discussing the legal requirements of an LLC filing taxes as an S Corporation. We need to draw a distinction here between an LLC being treated as an S Corporation for tax purposes and a business entity being filed as an S Corporation in the first place. The important difference is this — an LLC treated as an S Corporation for tax does not need to meet the other legal requirements demanded of entities initially created as S Corporations.
This means that unlike a standard S Corporation, an LLC filing as an S Corporation:
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Does not need to update or change its ownership structure — owners, members, and managers remain as they are.
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Does not need to create shareholders from officers or anyone else.
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Does not need to issue shares to anyone.
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Does not need to hold minuted meetings or file minutes with any agency.
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Does not need to meet other legal requirements demanded from S Corporations.
Update of LLC Operating Agreement
The only other change you will need to make is updating your LLC operating agreement that governs how your business operates. This should reflect the change in status to filing taxes as an S Corporation and be signed by all owners, members, and managers.
That’s it! We hope this comprehensive guide has told you everything you need about why, how, and what’s needed for filing and being treated as an S corporation for tax purposes.
Further Resources from the IRS
*Please note, all amounts and examples shown are greatly simplified and used for illustrative purposes only. Everyone’s tax situation is different, so speak to your accountant about your unique circumstances.
