QUESTION:
One of our founders asked, “I heard that an LLC can be treated as an S Corporation, but what does that mean? I’m confused. How can that be possible?”
ANSWER:
I found this article that answers your question really well. It’s from S Corporations Explained site, and here’s the excerpt:
What, exactly, is an S corporation?
Business people (and sadly even some accountants and lawyers who should know better) get confused about exactly what an S corporation is. So this is a good question.
In a nutshell, an S Corporation is a corporation, partnership or limited liability company that’s made an S election with the IRS.
And, yes, you did just read right. An S Corporation doesn’t have to actually be a corporation. It needs only to be what the Internal Revenue Service considers an eligible entity.
You should therefore think about an S corporation not as a “legal entity” but rather as a tax accounting classification.
Just to go into this definition a bit further, the S election tells the IRS that the business wants to be treated under the rules of Subchapter S of the Internal Revenue Code.
While there are many complicated provisions in Subchapter S, the basic feature of an S corporation is easy to understand: S corporation taxable income or S corporation tax deductible loss is allocated to the S corporation owners based on their ownership percentages.
An S corporation that makes, say, $100,000 in profits pays no income taxes on that profit. Instead, the shareholders of the S corporation include the profit on their returns.
If two shareholders equally own an S corporation that makes $100,000, for example, each shareholder adds $50,000 of income to his or her return and then pays the tax on that $50,000 profit from the S Corporation.
Two quick final comments about choosing to operate as an S corporation: First, just to be clear on this point, small business owners use S corporations to minimize the amount they pay in payroll taxes. The S corporation minimizes amounts shareholder-employees pay in payroll taxes because the S corporation profit allocated to a shareholder isn’t subject to payroll taxes.
And now a second comment: The catch with an S corporation is that the salary you set for a shareholder-employer such as the owner needs to be reasonable. A low salary might save payroll taxes temporarily, but the IRS should be able to successfully challenge such a salary. The 1120S tax return, which is what an S corporation files, makes it very easy to see when shareholder-employees are under-compensating themselves.
And here’s more on LLCs treated as S Corporations from the related site:
If an LLC makes an election to be treated as an S corporation, the LLC’s profits are subject neither to self-employment taxes nor to corporate income tax. The S corporation does need to file an 1120S tax return, however, and through this tax return the LLC’s owners get taxed on their respective shares of the corporation’s profit. Note that if an LLC owner works in the business, the LLC-treated-as-an-S corporation must pay a reasonable wage to the LLC owner. The LLC absolutely does owe payroll taxes on these wages.
I also suggest reading Wikipedia on S Corporation, which describes S Corporation in good detail.
Note: Before making any business decisions based on information on this site, it is your responsibility to check with your counsel or professionals familiar with your situation.
Founders Tip: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.
Thanks for kind words Ethan.
If it’s not too bold, I would point out that the typical situation where I as a CPA recommend the S corporation option is a one owner operation where the business makes, say, $100,000, $200,000, $400,000 etc…
In these sorts of situations, some of the partnership accounting flexibility that you reference above isn’t an issue (because there’s only a single owner). And owners in these situations typically save thousands or tens of thousands in self-employment and payroll taxes.
Steve
Bear in mind that electing to treat an LLC as an S corporation eliminates many of the advantages of the LLC. To qualify for an s election, you have to comply with a number of restrictions. For this discussion, the most important is that you can only have one class of membership interest. That means that you can't take advantage of the near infinite flexibility the LLC offers you in structuring the participants' interests. That said, an LLC can still offer slightly simpler maintenance, compared to a corporation. For example, you don't have to have annual meetings if you don't want them. So if you don't need the flexibility and can meet the other requirements to be eligible for an s election, forming an LLC and making an s election can be a good way to go.
If you want a pass-through entity and the employment tax advantages of an s corporation are important for your business, but you need more flexibility than the s corporation allows, you should consider using a limited partnership. The downside of the limited partnership is that you have to have a general partner: someone who bears unlimited liability for the partnership's obligations. In practice, however, you can avoid placing unlimited liability on any of the participants by forming another limited liability entity (e.g. a corporation or an LLC) to serve as general partner. That adds a bit of complication to the structure, but it's often worth it to achieve your overall business and tax goals.