If your business is an LLC (limited liability company), your personal liability for any business debts is limited to your investment in the LLC. When it comes to tax, though, there is no LLC classification with the IRS.
By default, single-owner LLCs are taxed as sole proprietorships and multiple-owner LLCs as partnerships. So, the profits of the business are taxed just once, in the hands of the owners. This “pass-through” taxation can be advantageous because it avoids the double taxation that corporations are subject to.
Corporate profits are taxed once at corporate tax rates, and again, when owners receive dividends. What many people don’t know is that LLCs can elect to be taxed as S Corps.
What’s an S Corp?
S Corp is not a business structure or entity. It is a tax designation with the IRS, meaning you have elected for your business to be taxed in terms of Subchapter S of Chapter 1 of the Internal Revenue Service Code.
What’s the advantage of an S Corp?
Valid business expenses are tax-deductible for both LLCs and S Corps. But in an LLC, the entire profits of the business pass-through to the owner who must pay income tax and self-employment taxes (like Medicare and Social Security) on the whole amount. In an S Corp, owners become employees and must be paid market-related salaries. They pay self-employment taxes on their wages alone. The profits of the company get passed to owners as dividends and are subject to income tax only, as there is no corporate tax rate for S Corps.
Are there any disadvantages or restrictions to an S Corp?
Not all LLCs may become S Corps – the IRS places some restrictions on S Corps:
- LLCs can have unlimited owners, but S Corps cannot have more than 100.
- LLC owners are not required to reside in the U.S. or to be U.S. citizens, but S Corp owners are not permitted to be non-resident aliens.
- LLC owners may be other legal entities such as trusts and C corporations, but S Corp owners must all be individuals.
- LLCs may distribute profits to owners as they see fit, but in an S Corp, all owners must share in profits in proportion to their shareholding percentages.
These restrictions on ownership can limit funding and future sale of the business, and should not be accepted without careful consideration.
S Corps are also required to adopt certain bylaws, hold annual shareholders meetings, and keep minutes of decisions. This can make them expensive to set up and cumbersome to run.
The 2017 Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act allows individuals taxed on income from a “pass-through” entity, including S Corps, to deduct 20% of qualifying business income (QBI) up to certain limits. QBI is calculated after wages – the lower the wages, the bigger the QBI. But for S Corps designation, owners’ wages must be market-related, which could mean any benefit is lost or reduced.
Anticipating tax benefits can get complicated, so it is always advisable to get a professional opinion on whether electing S Corp status will be justified. Consult with your CPA or tax attorney before making a decision.