Unlike an LLC, partnership, or C corp, an S corp isn’t actually a business structure. Instead, it is a tax designation that can be applied to a business. LLCs and corporations can both elect to be taxed as an S corp, provided they meet certain criteria.
The Default Tax Structure for an LLC
While LLCs have some flexibility in how they are taxed, their default tax structure is either a sole proprietorship or a partnership, depending on the number of members the business has. Both of these structures are considered “pass-through” entities. This means that the company’s profits are not taxed at the corporate level but are instead passed through to the company’s owners, who pay personal income tax on their share of profits. Pass through entities are also responsible for paying self-employment tax to cover both the employee and employer portion of Social Security and Medicare taxes. The current rate is 15.3%.
How an S Corp is Taxed
Companies that elect S corporation status are also taxed as pass-through entities and are subject to corporate taxation. Unlike sole proprietorships and partnerships, S corp owners can lower their self-employment tax liability by dividing their earnings between salaries and dividends. Owners of an S corp must be paid a “reasonable” salary (earned income) based on their position and industry, with the remainder of business profits distributed as dividends. While all profit is subject to personal income tax, self-employment tax is paid only on earned income.
An S corporation may invite closer scrutiny from the IRS because it uses a more complex tax designation than a sole proprietorship or partnership. This complexity can lead to more accounting or filing mistakes, which can result in the IRS stripping a business of its S corp status. If you choose this status it’s critical to abide by all IRS regulations.
Qualifications for an LLC to Be Taxed as an S Corp
One of the advantages of an LLC is that it has some flexibility in how it is taxed. While the default is to tax an LLC as a sole proprietorship or a partnership, your LLC may qualify for S corp tax designation.
Few restrictions exist for LLC ownership. Generally, there’s no maximum number of members permitted in an LLC and no citizenship requirements. An LLC can also be owned by other business entities such as corporations or other LLCs. In contrast, to qualify for S corp status, your business cannot have more than 100 owners, all owners must be U.S. citizens or permanent residents, and no other business entities may be owners.
How Does the Tax Cuts and Jobs Act Affect My LLC?
The Tax Cuts and Jobs Act of 2017 included a 20% deduction of “qualified business income” for the owners of pass-through entities. Qualified business income is the net profit your business earns during the year. If you elect S corp status, the deduction will not apply to profits paid out as wages. For more details on how this may or may not work for your business, see the IRS’s FAQ page or speak with a tax professional.
Steps to Elect S Corp Status for Your LLC
Electing S corp status for your LLC is a fairly simple process, provided that you already meet the ownership requirements. If your business qualifies, all you have to do is file IRS Form 2553 before March 15, and your LLC will be taxed as an S corp for the current tax year.