Innovative Strategies For Winning Tax Controversies, Business Structuring And Estate Planning

Filing As An LLC But Being Taxed As An S Corp

Background: An LLC taxed as an S corp is the same as a straight S corp. In addition to being a shareholder, the owner-officer of an S corp who performs services on behalf of the S corp is considered to be an employee of the S corp.

Therefore, there are two primary ways in which an owner-officer of an S corp would take funds out of the S corp:

  1. Via a shareholder distribution of profit
  2. In a salary for his or her work as an employee of the S corp

In an S corp, only salaries paid to employees are subject to employment taxes; shareholder distributions are not subject to employment taxes. The same would apply to the owner-employee of an LLC that is taxed as an S corp. This is in stark contrast to an LLC that does not make an election to be taxed as an S corp. By default, a single-member LLC (an LLC with only one owner) is a disregarded entity for tax purposes and treated by the IRS (Internal Revenue Service) as a sole proprietorship. Just like any other sole proprietor, the owner of this type of LLC is considered to be “self-employed” and, in addition to income tax, must pay a self-employment tax equal to 15.3% on net earnings from self-employment.

The self-employment tax is made up of two parts:

  • Social security tax (in 2009, on up to $106,000 of net earnings)
  • Medicare tax (on all net earnings of at least $400)

The self-employed owner of an LLC does not take a salary for his or her services. He or she can take an “owner’s draw,” or withdrawal of capital if desired. But the total net income would still be subject to self-employment tax as previously explained (as well as income tax), whether the owner takes an owner’s draw or not.

Advantages of LLC taxes as an S corp vs. a straight S corporation:

  1. Tax: An entity taxed as an S corporation allows the owners to save on self-employment taxes (which are 15.3% up to $106,800 of earned income in 2009) on distributions of profits. Because the owner of the LLC is self-employed, 15.3% of all earnings up to $106,800 in 2009 are subject to self-employment taxes. For instance, let’s say that you earned $60,000 last year in your LLC. You would pay $9,180 in self-employment tax. That money will go toward your Social Security and Medicaid payments. However, there is a way to earn a lucrative salary without taking a hit on all of the profits. Example: You formed an LLC taxed as an S Corporation. You earn the same amount of money but pay yourself a salary of $40,000. You’ll pay only $6,120 in self-employment tax. That’s a tax savings of $3,060. S corporations can elect to pay the remaining $20,000 in earnings as a distribution from the company. As an LLC, you can also elect to split the profits in this manner, as long as you follow IRS guidelines. That’s where the tax savings come into play. NOTE: It is very important to take a reasonable salary when you have either an S corporation or an LLC taxed as an S corporation. The IRS does not like an owner of an S corporation to take only distributions that are not subject to SE taxes. A reasonable salary is key.
  2. Limited Liability, i.e. “charging order” protection.
  3. Easier to manage: Not subject to corporate formalities and record keeping requirements such as annual shareholder meetings, board resolutions and meeting minutes, etc.

General comment: Keep in mind that an LLC taxed as an S corporation may not be beneficial to everyone.

For example, in California, a licensed professional cannot form an LLC so their best option may be a corporation. Because you have three months to file for S Corporation tax status, make it a priority to seek professional assistance before making the final decision. For many small business owners, however, the ease of management that a limited liability company offers combined with the lower taxes of an S corporation makes this decision an easy one to make. The LLC can do whatever it wants, but it’s going to lose S status if it doesn’t have a single class of “stock.”

Distributions are going to be based on the operating agreement but they had better be in simple proportion to membership interests, unless you can be clear that some of them will be treated as payment for services (or something else) rather than on account of owning the interest. You can have different classes of members to give different control rights, but not different entitlements to distribution.

Note: An LLC can have whatever members and income it wants. If it has too many members, multiple classes of stock, ineligible shareholders or any other disqualifying element, it will lose its status as an S corporation, the same as with any other corporation.

Problems with LLC taxed as a corporation:

  1. Can be a source of confusion for business owners who attempt to prepare their tax returns themselves. Often self-preparers look to IRS publications for assistance in preparing their tax returns, and in so doing, may inadvertently apply the rules regarding traditional LLCs when, in fact, S corp rules apply.
  2. Also, a business owner may not know that certain transactions that would not otherwise be taxable events with a traditional LLC (e.g., the transfer of assets between the company and its owner) could have tax implications with an LLC that is taxed as an S corp.
  3. The flexibility of multiple classes of ownership and ownership rights in an LLC is eliminated.
  4. Family-owned businesses cannot transfer equity and control to the next generation as easy as an LLC treated as a partnership.
  5. Most states require owners to pay unemployment and disability taxes then prohibit them from collecting the benefits.