Trying to Decide Whether to be Taxed as an S-Corp?

Help! Should I Be An S-Corp?

Without fail, at least twice a week, a panicked business owner reaches out to me, concerned that they were set up as a limited liability company (“LLC”) and heard that they needed to be an S-Corp. They aren’t sure what either means, but they are panicking between Google and their well-meaning friends! And while the internet (and your well-meaning friends) are full of “advice,” they don’t always know what is best for you and your business. If this is you, take a deep breath and then read on – in today’s post, we’re talking about the differences between LLCs and S-Corps, and the essential information you need to know about each.

Back to basics: What exactly are LLCs and S-Corps?

Much of the confusion around LLCs and S-Corps stems from the fact that most business owners don’t know what they are.  Let’s change that.

A Limited Liability Company is a Type of Business Entity

A Limited Liability Company is a type of business entity. Once established, it is considered a person under the law and can transact business in its name (as opposed to its members’ name). This allows its members to combine the liability protections of a traditional corporation with the flexibility provided to sole proprietors and partnerships. In general, LLCs:

  • Are one of the most common types of new businesses, especially for smaller, service-based companies
  • Protect its members from personal liability for obligations incurred by Company
  • Are easy to form and less formal than a traditional corporation but provide more legal protections than being a sole proprietor or partnership.
  • Members can choose how they want to be taxed

The LLC structure makes the most sense for many businesses I talk to – they want their assets protected and flexible. Let’s chat if you’re not an LLC or don’t think an LLC is suitable for you. Otherwise, keep reading!

S-Corporation (or S-Corp) is a Type of Tax Election

The IRS allows certain Corporations (and LLCs, but we’ll get to that in a minute) to elect to be taxed under Subchapter S of the Internal Revenue Code. This means the corporation’s tax burden passes through to its shareholders, who claim earnings/losses on their personal income tax returns as opposed to being taxed on both the company’s earnings and shareholder distributions. These types of corporations are called S-Corps, and to qualify the company:

  • Must be a domestic Corporation
  • Have no more than 100 shareholders (shareholders may be individuals, certain types of trusts and estates, but they may not be partnerships, corporations, or non-resident aliens)
  • May only have one class of stock

Classifying an LLC as an S-Corp For Tax Purposes

One of the benefits of choosing an LLC as your business entity is that you have flexibility in how you are taxed. The default classification is as a sole proprietor (for single-member LLCs) or as a partnership (for multi-member LLCs).  But, and here is where the confusion comes in, LLCs can elect to be taxed AS AN S-CORP.

So, what does that mean?  If it makes sense for your business, you can elect S-Corp status with the IRS.  Let’s look at when it might make sense.

Taxation under a Sole Proprietor or Partnership Classification

Many small businesses, especially those run by solopreneurs with no employees, stick with the default classification. Why? It’s fairly straightforward to administer.

  • The LLC is a pass-through entity for tax purposes – essentially, that means that all profit/losses flow to the members.
  • Members pay themselves via distributions and must file estimated taxes with the IRS.
  • Because Members are responsible for all the taxes associated with the LLC (both payroll and income), they are subject to paying the “Self-Employment Tax”, which refers to the member paying a higher rate for their Social Security & Medicare taxes. This tax is due on all profits earned by the LLC.

S-Corp Classification for LLCs

An LLC can elect to be taxed as an S-Corp with the IRS.  One of the most significant benefits for members filing as an S-Corp is that they can avoid the Self-Employment Tax because the LLC pays a portion of this tax on their behalf. Other things to keep in mind when choosing an S-Corp election:

  • Members who are employed by the LLC must be paid a reasonable salary.
  • Payroll taxes are assessed at the time the Member / Employee is paid.
  • Because payroll taxes are only assessed on a member’s wages, the LLC’s remaining income may be taxed at a lower rate.

Determining How Your LLC Should Be Taxed

Now that you know the basics, which should you choose? That decision isn’t as cut and dry as many online commentators would have you think. When looking at how they want to be taxed, LLCs need to consider:

  • The number of members
  • How many W-2 employees the business has
  • Annual revenue
  • How do the members intend to be paid (i.e., are you foregoing a salary during the first year or two as the business takes off?)

Smaller solopreneurs may be better off with the default classification because of its simplicity. At the same time, businesses with higher annual revenues and multiple employees will want to avoid the self-employment tax. And, despite what you may read online, there is no cookie-cutter answer – what works for your business may not work for your friends, and vice versa. Your best bet? Make an appointment with a business attorney or your accountant and talk through your goals (both short-term and long-term) to decide which strategy works best for you and your business.

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