As you may know if you’ve spent time browsing the pages of this website, a limited liability company that meets all the eligibility criteria may elect to be treated as an S corporation. In other words, a limited liability company can often choose to use the S corporation tax accounting rules.
People sometimes get confused about the S corporation option. But the thing to understand is that an S corporation is not a corporation but a tax accounting classification that the IRS allows a bunch of different entities to use. Predictably, the IRS allows traditional corporations to use the S corporation accounting classification. But the Internal Revenue Service also allows other entities to use the S corporation accounting classification, too–including limited liability companies, limited partnerships, professional limited liability companies, and so forth.
So, when should an LLC elect to be treated as an S corporation? In general, a limited liability company benefits by electing to be treated as an S corporation when the owner or owners run a profitable business and want to minimize the payroll taxes (including self-employment taxes, Social Security taxes, and Medicare taxes) they pay.
But let me explain… Suppose you operate a small business as a single member LLC and have accepted the default tax accounting classification, which is “sole proprietorship”. Further suppose that you make $100,000 a year. In this case, you will pay probably about $10,000 annually in income taxes. And you will pay close to $15,000 in self-employment tax.
In total, your business tax bill will run $25,000 a year. Ouch.
But here’s what happens if you elect to have your limited liability company treated as an S corporation. You will need to split your $100,000 of profit into two chunks: a wages chunk and a distribution chunk. Suppose, for example, that you split your business profit into $50,000 of wages and $50,000 of distribution. In this case, you still pay the same, say, $10,000 of income taxes. But you will only pay the roughly 15% employment tax on the $50,000 wages. Paying a 15% employment tax on $50,000 of wages rather than a 15% tax on a $100,000 of sole proprietorship profit cuts your employment taxes from roughly $15,000 a year to roughly $7,500 a year.
Anyway, that’s the first way in which an S corporation saves limited liability company owner’s taxes.
Caution: Tax law says you must set your salary to a reasonably compensation amount. You can’t, therefore, use an S corporation to eliminate your employment taxes. Also, you should also know that in a case of one-person service business with no assets or no employees, the IRS often thinks that 100% of the business profit should be paid as a wages.
Let me also raise another potential tax benefit related to treating a single-member LLC as an S corporation. When the business owner has significant individual tax deductions he or she is claiming on their 1040 return, some of those tax deductions can commonly be moved to the S corporation tax return. In this case, even though the business owner doesn’t save payroll taxes by setting a low salary, the business owner saves payroll tax by having the S corporation pay directly some of these deductions.
Examples of deductions that can be paid with “pre-employment-tax” dollars when moved to the S corporation tax return include pension plan contributions, self-employed health insurance deductions, and charitable contributions. The bookkeeping is a little bit tricky the first time you move these deductions. Accordingly, you may need some help from an accountant. But deal with these deductions correctly, and in effect, the deductions not only save you income taxes but they also save you employment taxes.
Note: If an LLC is treated as a sole proprietorship, pension plan contributions, self-employed health insurance premiums and charitable contributions often do get treated as income tax deductions. But they don’t save the business owner any self-employment taxes. When an S corporation puts these deductions on the corporate return, however, the deductions typically save both income taxes and payroll taxes.