LLCs are en vogue for new businesses because of their versatility and simplicity. They provide the liability protection of a corporation with far less organizational maintenance. Tax treatment can be changed, ownership interests can be owned by individuals, trusts or business entities, and charging order protection is afforded.
If you already have an LLC, you might have heard of S-elections and wonder whether an S-election makes sense for you. I’ll explain by outlining the benefits of making an S-election and then discuss the drawbacks. First, though, what is an S-election?
The S refers to Subchapter S of chapter 1 of the Internal Revenue Code. An LLC is a state-created business entity not formally recognized by the IRS. When an LLC is formed, its default taxation is based on the number of members (another word for owners). If it’s a single-member LLC, then it’s taxed as a sole proprietorship. If there is more than one member, it’s taxed as a partnership. Rather than accept the default tax classification, an owner can elect to be taxed as a C-corporation, which is the standard corporation, or an S-corporation. Hence the name: S-election. It’s important to note that an LLC taxed as an S-Corporation is not, itself, an S-corporation. The LLC is still managed and operated according to the LLC operating agreement. The LLC is only taxed as an S-corporation.
The key benefit of this election is employment tax savings. LLC owners do not receive compensation as employees of the company, but instead take owner distributions. All profits pass through from the company to the individual owner’s personal tax return. That owner is responsible for self-employment taxes (or SE taxes) on those profits at a rate of 15.3%. An S-corporation distinguishes between employee wages and owner distributions. In a single-member LLC, the owner who performs services for the company can be deemed an employee. The IRS assesses an employment tax on the wages earned by the owner-employee, but does not assess employment taxes on distributions taken by the owner.
Let’s look at an example. In 2009, Lisa ran a computer consulting business. After adding up all her revenue and subtracting her overhead expenses, she earned $50,000 in profits. That income passed through to her personal tax return and she was responsible for $7,650 in SE taxes (15.3% of $50,000). Enter the S-election.
Lisa made an S-election at the beginning of the year by filing form 2553. She earned the same $50,000 in profits. However, based on her part-time hours she determined that a reasonable annual wage for a computer consultant in her area also working part-time hours would be $25,000. She paid that to herself as wages and was taxed the same 15.3% rate in the form of payroll tax resulting in $3,825. However, the remaining $25,000 she took as a distribution employment tax-free. The result was an employment tax savings of $3,825!
So what’s the drawback? In the first scenario, Lisa could take distributions in any amount, at any time. Her tax payment wasn’t due with her personal income taxes until April 15 of the following year. As an employee in the second scenario, she was subject to the payroll tax, which required filing quite a bit of paperwork with the state and the IRS. She also needed to pay herself and the payroll tax at regular intervals throughout the year. Scenario two requires a lot more planning, paperwork and oversight. Much of that work can be delegated to a payroll company for a fee. Usually between $40 and $50 per month depending on the company size.Finally, Lisa should not try to abuse the system by paying herself only a nominal wage and taking the rest as a tax-free distribution. The IRS requires the wage to be “reasonable.” Many accountants advise as a rule of thumb dipping no lower than a 50/50 split.
Making an S-election on your LLC can provide you the best of both worlds in flexibility and tax savings. It is wise to consult with your CPA before making the jump and even wiser to use a payroll company when the decision to elect has been made.