LLC vs S corp: what the tax election changes and what it does not

People ask “LLC or S corp?” as if they were two different things to form. They are answers to two different questions. The state question is what kind of entity you are. The IRS question is how that entity’s income is taxed. You can be an LLC for the state and an S corp for the IRS at the same time.

How an LLC is taxed by default

The IRS says a one-member LLC is treated as disregarded from its owner by default. The income goes on the owner’s own return. An LLC with two or more members is treated as a partnership. Either way, the LLC itself usually does not pay federal income tax. The owners do.

The owners also usually pay self-employment tax on their share of the profit. The IRS says the self-employment tax rate is 15.3%: 12.4% for Social Security and 2.9% for Medicare. It applies when net earnings from self-employment are $400 or more. That tax is the main reason owners look at an S corp.

What the S corp election changes

The IRS says an S corporation passes its income, losses, deductions, and credits through to its shareholders, who report them on their own returns. So income tax still flows through to you, as it does with a default LLC. What changes is how you are paid.

• You become an employee. The IRS says an S corporation must pay reasonable compensation to a shareholder-employee before making non-wage distributions. That salary runs through payroll, with payroll taxes.
• The rest can come out as distributions. Profit above a reasonable salary can be paid as distributions, which are not wages. This is where the possible savings come from.
• The salary has to be reasonable. The IRS lists the factors it looks at, including training and experience, duties, time spent on the business, and what comparable businesses pay for similar services. A tiny salary to avoid payroll tax is the kind of thing the IRS checks.

The election also adds work. You run payroll for yourself. The company files its own return, Form 1120-S, and gives each owner a Schedule K-1. Many owners pay an accountant for both.

Who can elect

The IRS sets the rules. To be an S corporation, the company must:

• Be a domestic company.
• Have only allowable shareholders: individuals, certain trusts, and estates. Partnerships, corporations, and nonresident aliens cannot be shareholders.
• Have no more than 100 shareholders.
• Have only one class of stock.
• Not be an ineligible type, such as certain financial institutions and insurance companies.

For an LLC, an operating agreement that pays owners in a way that does not match their ownership can raise a one-class question. Have an accountant read it before you elect.

How to elect

1. Run the numbers. Compare self-employment tax on the whole profit against payroll tax on a reasonable salary, plus the cost of payroll and an extra return.
2. File Form 2553. All shareholders sign it. The IRS instructions say to file it no more than 2 months and 15 days after the start of the tax year it should take effect, or at any time in the year before.
3. Skip Form 8832 in most cases. The instructions say an eligible entity that meets the tests is treated as a corporation from the election’s effective date, so it does not need to file Form 8832 too.
4. Set up payroll before you pay yourself.

If you miss the deadline, the instructions describe relief for a late election with reasonable cause, filed within 3 years and 75 days of the intended effective date. Outside that, it generally takes a private letter ruling and a user fee.

What stays the same with the state

The S corp election is between you and the IRS. The state where you formed the LLC still sees an LLC.

• The registered agent. The LLC still needs one at a street in the state. The tax election does not change who can be handed a lawsuit for the company. What is a registered agent for an LLC? covers the job.
• The yearly state filing. Michigan’s LLC annual statement, $25 and due February 15, still applies to an LLC taxed as an S corp. So does Indiana’s Business Entity Report. LLC annual report covers the dates.
• The name and the articles. You do not refile as a corporation. The name still says LLC.

State income taxes are another matter. Some states treat S corps their own way. Ask your accountant how your state handles it. The Michigan scorecard and the Indiana scorecard cover the agent side for those states.

When the election usually does not fit

• Low profit. If profit is small, payroll costs and the extra return can eat the savings.
• Owners who cannot be shareholders, such as another company or a nonresident alien.
• Uneven deals among partners that do not follow ownership percentages.

If you are just starting, form the LLC first. How to start an LLC, step by step covers that. The election can come later, once there is profit to look at.