What Is an S-Corp?
One of the most important things to understand is that an S-Corporation, or S-Corp, is not a business structure. Rather, an S-Corp is a specific tax classification that can be adopted by either an LLC or Corporation.
Salaries and distributions are taxed differently in an S-Corp than they are in a default LLC. This allows S-Corps to have certain benefits and opportunities that default LLCs do not have.
In order to be considered for S-Corp status, your business will need to meet certain requirements. S-Corporations must:
- Not have more than 100 shareholders
- The owners must be US citizens or permanent legal residents
- The owners must be private individuals and not business entities. This means that the business can not be owned by separate businesses like LLCs, corporations, or trusts.
- Can only issue one class of stock
Benefits of an S-Corp
S-Corps have a number of benefits when compared with default LLCs, specifically in regards to how salaries and distributions are taxed.
In an LLC under the default rules, the owners of the business are classified as members by the IRS. LLC members are not employees and are not paid a salary. Members are instead compensated in the form of distributions, which includes payment of work and profit sharing for the LLC. Because the payment is a distribution, you are required to pay employment taxes on the entire distribution, plus income tax.
When an LLC chooses to be taxed as an S-Corp, members can now be considered as employees and can now earn a regular salary. In addition to the salary, employees can also receive distribution for profit sharing of the company.
Because payment is divided as both a salary and a distribution under an S-Corp, they are taxed differently. While the salary is still subject to both employment and income taxes, the distribution is only subject to the income tax. This prevents you from having to pay any employment taxes on your distribution.
Disadvantages of an S-Corp
While there are some significant tax savings that an S-Corp enjoys, there are some reasons why S-Corps are not beneficial for all LLCs.
As an S-Corp owner, the IRS does require that the owner be paid a reasonable salary. A reasonable salary is any salary that you would pay to a separate employee to do the same job as the owner.
Because of the tax benefits that S-Corps receive, they are subject to increased scrutiny by the IRS. If the owner is not paid a reasonable salary, this may lead to the IRS denying your S-Corp status and leading to further payment of back taxes and fines.
Another disadvantage of an S-Corp are the amount of requirements that they must follow. In addition to having the ownership be paid a reasonable salary, S-Corps also have a number of complex administrative costs needed to operate, including payroll and tax withholdings. The increased complexity of complying with these requirements will lead to increased costs.
Because of these increased costs, S-Corps are not necessarily the best option for all scenarios. If your business is not making at least $10,000 as distribution, being an S-Corp is not really worthwhile because of the additional attributed costs.
Should Your LLC Become an S-Corp?
In order to decide if your LLC should apply for S-Corp tax status, there are a few criteria and intentions that you should consider. This ultimately comes down to how much profit your business is going to make at the end of each year.
If you are unsure how much profit you will make or if you want to reinvest the profits back into your LLC, it’s best to stay as an LLC. You can always apply for an S-Corp status at a later when it better suits your business.
If you know your business is going to make a distribution that is greater than $10,000 after paying yourself a reasonable salary, than your business has enough profit to justify becoming an S-Corp. To elect to become an S-Corp, you will just need to file Form 2553 with the IRS to reclassify your LLC.