LLC vs. S Corp: When to consider switching (Part 1)
Disclaimer: This article is intended for general informational purposes and does not constitute individualized tax or legal advice. Tax treatment depends on the specific facts and circumstances of each taxpayer and business.
Should your LLC elect an S Corp tax status?
One of the most common questions we receive from business owners is whether they should elect to have their LLC taxed as an S Corporation (S Corp).
An S Corp election can provide meaningful tax savings for the right business owner, but it also creates additional payroll, tax filing, accounting, and compliance requirements. The decision should be based on the economics of your business — not simply because someone told you that every LLC should be an S Corp.
An LLC and an S Corp are not the same thing
A common misconception is that an LLC and an S Corp are two different types of businesses you must choose between.
An LLC is a legal entity created under state law. An S Corp is a federal tax classification.
For example, a single-member LLC is generally taxed as a sole proprietorship by default. The business's income and expenses are typically reported on the Schedule C of the owner's individual tax return.
However, that same LLC may be eligible to elect to be taxed as an S Corp.
Legally, the LLC still exists — it has simply changed how it is treated for federal income tax purposes. This also has a state tax implication for franchise and excise tax.
Why do business owners consider an S Corp election?
The primary potential benefit is employment tax savings.
For a typical Schedule C business, the owner's net business income is generally subject to self-employment tax, in addition to federal and potentially state income taxes.
An S Corp works differently.
An owner who actively works in the business generally receives compensation through two primary channels:
W-2 wages for services performed for the business; and
S Corp profit/distributions attributable to ownership
The owner's wages are subject to the applicable payroll taxes. However, the remaining S Corp pass-through income generally is not subject to self-employment tax.
That distinction can create meaningful tax savings.
Example (simple)
Assume a consultant operates an LLC generating $150,000 of profit before owner compensation.
If the LLC is taxed as a sole proprietorship, most or all of that business profit may be subject to self-employment tax.
Now assume the LLC elects S Corp status and, after reviewing the owner's duties and market compensation, determines that $75,000 is reasonable compensation.
The owner receives:
$75,000 of W-2 wages
Remaining business profit through the S Corp
The wages remain subject to payroll taxes, but the remaining S Corp profit generally is not subject to self-employment tax.
That difference is where much of the potential S Corp tax savings comes from.
However, you cannot simply choose an artificially low salary to maximize the savings.
The reasonable compensation requirement
If you work in your S Corp, the IRS generally requires you to pay yourself reasonable compensation before taking non-wage distributions.
However, there is no universal rule stating that an owner must take a particular percentage of profit as salary.
Reasonable compensation depends on the specific facts of the business and may include factors such as:
the owner's responsibilities and duties
time devoted to the business
experience and professional qualifications
compensation paid for comparable positions
the nature of the business
services performed by other employees
how the business generates its revenue
A professional services business, in which substantially all of the revenue is generated through the owner's labor, may warrant a different compensation analysis than a business generating significant income from employees, equipment, intellectual property, or invested capital.
Simply paying yourself an extremely low salary while taking substantial distributions can create unnecessary tax risk.
Considering an S Corp election?
If your LLC has become consistently profitable, it may be worth evaluating whether an S Corp election could reduce your overall tax burden.
At Jon Acevedo, CPA, LLC, we help business owners evaluate their current tax structure, estimate potential S Corp tax savings, determine an appropriate compensation strategy, and implement the election when it makes financial sense.
Before making the change, we recommend reviewing:
current and projected business profit
reasonable owner compensation
estimated payroll-tax savings
state tax implications
payroll and compliance costs
retirement plan opportunities
long-term business and ownership plans
An S Corp can be an excellent tax-planning tool, but the goal is not simply to become an S Corp.
The goal is to choose the tax structure that makes the most sense for your business.
If you would like to discuss more about this topic with us, please reach out using the contact form. We look forward to hearing from you!
Thank you for reading our blog! Here are some helpful deadlines and notes:
Key tax deadlines
Individuals
April 15 – Federal individual income tax return due (Form 1040)
October 15 – Extended individual filing deadline
Estimated tax payments
April 15 – 1st Quarter payment due
June 15 – 2nd Quarter payment due
September 15 – 3rd Quarter payment due
January 15 – 4th Quarter payment due (following year)
Businesses
March 15 – Partnerships (Form 1065) and S-Corporations (Form 1120-S) due
April 15 – C-Corporations (Form 1120) due
September 15 – Extended deadline for Partnerships and S-Corporations
October 15 – Extended deadline for C-Corporations
Important reminder
An extension provides additional time to file a tax return, but not additional time to pay. Any expected tax liability should generally be paid by the original due date to minimize penalties and interest.
Current clients
Please upload tax documents through the secure client portal whenever possible. Additionally, please do not send Social Security numbers, tax returns, or other sensitive information by email. If you received an IRS or state notice, please upload the complete notice, including all pages.
Submission of documents does not constitute completion of a tax return. We will contact you if additional information is needed.
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