Should I Elect to Have My LLC Taxed as a Corporation or S Corp?
How to Change LLC Tax Status to Corporation or S Corporation
The limited liability company (LLC) form of business is the newest invention in business forms. It's also the most flexible, especially when it comes to taxes. An LLC can be taxed in several different ways to save on taxes for the business and its owner.
In this article, we'll look at the LLC form of business, how an LLC is usually taxed, how being taxed as a corporation can be of benefit to the business, and the process of electing this tax option.
Should You Elect to Have Your LLC Taxed as a Corporation?
An LLC may elect to be taxed as a corporation or S corporation, instead of a partnership or sole proprietorship. Since many tax advisers extol the advantages of the LLC form of business, why would an LLC want to be taxed as a corporation?
How LLCs Are Taxed
By default, if you do not elect otherwise, your LLC is taxed in one of two ways, depending on how many owners members are in the LLC:
- A single-member LLC is considered a disregarded entity and is taxed as a sole proprietorship, filing Schedule C for the individual's personal tax return.
- A multiple-member LLC is taxed as a partnership. The partnership files an information return on Form 1065, with Schedule K-1's for each member/partner.
LLC owners must pay self-employment tax (Social Security/Medicare) on all of their income from the business. These tax situations are what the IRS calls the "default" for income tax for an LLC.
Advantages of LLC Taxed as a Corporation
Usually, businesses select the tax form that will yield the lowest taxes. The personal tax rate (for sole proprietorships and partnerships) at the high end of the tax tables is higher than the highest corporate rate (at 21 percent, beginning with the 2018 tax year), so if your total taxable income (adjusted gross income), including your LLC net income, is very high, you might want to remove your business from being included in your personal taxes. Having the LLC taxed as a corporation does this.
The main advantage of having an LLC taxed as a corporation is the benefit to the owner of not having to take all of the business income on your personal tax return. You also don't have to pay self-employment tax (Social Security/Medicare) on income from your corporation unless you work as an employee in the business. Let's look at a scenario:
Your LLC has a net profit of $50,000 for the year. If you are the only owner of the LLC, you must take all of this profit on your personal income tax return. If you have the LLC taxed as a corporation, you can retain some or all of the profit (keep it in the business) and not pay personal income tax on this profit.
The Disadvantage of the Election to Be Taxed as a Corporation
One big advantage of an LLC is that owners avoid double taxation — paying taxes on the income of the corporation (not on your personal tax return) and also on income received as dividends. If you decide to have your LLC taxed as a corporation, you (as the owner) will be subject to this double tax situation.
Advantages of LLC Taxed as an S Corporation
An S corporation is a special kind of corporation that has some tax advantages. Owners can split their income from the S corporation between a distribution (in the same way as a partner) and status as an employee. This status allows S corp owners to pay less self-employment tax (Social Security/Medicare), as long as the S corp owner/employee is paid a reasonable salary.
To qualify to be taxed as an S corporation, the business must meet specific requirements:
- the business can have no more than 100 shareholders
- no shareholder can be a nonresident alien (noncitizen who doesn't live in the U.S.
- there can be only one class of stock
- all shareholders must be individuals (not other businesses)
Another advantage of S corporation status is that an S corp owner can take a 20 percent tax deduction from his or her share of business income, in addition to usual deductions for business expenses. This Qualified Business Income (QBI) deduction is calculated on the owner's income as an employee. This deduction is not available for personal service businesses like accounting, law, consulting, or financial services. Also, the QBI deduction is limited or not available for higher-income business owners.
Many LLC's choose the S corporation for its tax status because the S corp allows the owner to take the QBI deduction on business income (not employment income) and the owner pays self-employment tax only on employment income.
How to Make the Election
If you decide to make this election, here is some more information you need to know:
To be taxed as a Corporation, use IRS Form 8832 — Entity Classification Election. The election to be taxed as the new entity will be in effect on the date entered on line 8 of Form 8832. The election cannot take effect more than 75 days before the date the election is filed, nor can it take effect later than 12 months after the date the election is filed.
- The form allows "eligible entities" to file this election. LLCs are specifically stated to be eligible entities.
- An LLC files this election to be an "association." The IRS uses the term "association" to mean "an eligible entity taxable as a corporation by-election..."
- The form includes a consent statement which may be signed by all members, or by one member on behalf of all members. If one member signs, there should be some record in company membership meetings that all members approved this election.
- You must provide the name(s) and identifying the number(s) of owners (Social Security Number for a single-member LLC, and Employer ID Number for multiple member LLC).
To be taxed as an S Corporation, use IRS Form 2553 - Election by a Small Business Corporation. To begin the new tax classification for a year, you must file by March 15, effective for the entire year. You will need to include information about each shareholder: name and address, shares owned, Social Security number, the date the owner's tax year ends, and a consent statement.
What Happens to the Old Entity
For a change to a corporation, when your election to corporate status becomes effective, the IRS determines that all the assets and liabilities of the previous business (sole proprietorship or partnership) are contributed to the corporation in exchange for shares of the corporate stock.
For more information, see this IRS article about LLCs filing as corporations vs partnerships.
Disclaimer: This information is provided to give you a general knowledge of the subject and to allow you to have information to discuss with your attorney, CPA, or tax adviser. Every business situation is unique, and taxes and laws change regularly.