There are a number of different structural entities that businesses can choose to form, each with its own associated advantages and disadvantages. Limited liability companies (LLCs) and corporations are two of the most common entity types because their benefits are perfectly suited to small and medium-sized enterprises (SMEs), and they are relatively straightforward as well as cheap to form. However, this does not necessarily mean that formation is easy. Many businesses need to set aside time and capital to ensure that not only is their formation process successful, but that the intended entity is truly the right fit for the business. This can often entail tedious documentation, planning, research, and strategy. However, it is always in the best interest of any business to designate this time and effort in order to optimize their formation and its benefits.
It is also a very popular choice for business owners to file S-corporation (S-corp) status with the IRS. While it is a common misconception to confuse S-corps as being one of these business entity types, this is not the case. Rather, S-corps are a tax designation that LLCs can elect, but what does this entail and why would a business choose this designation? This article will explain all this and more.
Table of Contents
What Is An S-Corp?
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As stated above, an S-Corp is a tax designation that LLCs can elect by filing Form 2553 Election by a Small Business Corporation with the IRS to be recognized as. Under this IRS tax classification, the manner in which the LLC’s profits are taxed differs from the standard LLC tax system.
Under the default LLC tax system, the company’s net profit passes through to its members (or owners), who are then liable to pay both personal income taxes (dependent on their individual rate) and self-employment payroll taxes for Medicare and FICA based on the salary and distributions they pay themselves from the LLC’s revenue.
Contrastingly, in an S-Corp tax classification, the owners of an LLC are taxed as employees of the company (in an analogous way to the manner in which corporation owners are taxed). Furthermore, the LLC is required to pay its members what the IRS refers to as “reasonable compensation” for the duties they perform. Income and payroll taxes are paid on this salary, but only income taxes need to be paid on any distributions.
What Are The Benefits?
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When used correctly, the S-Corp tax status enables the members of an LLC to retain more of their earnings after tax. It does this by eliminating self-employment taxes and permitting business owners to transfer some of their income before tax into a health insurance premium or 401(k), all of which reduces the total amount an LLC owes in taxes. S-Corps also have compelling characterizations of income. Shareholders can earn salaries as employees, receive dividends, and other appealing forms of compensation that are, in some cases, tax-free. This helps minimize the overall personal tax liability.
This is the primary benefit of S-Corps. They have the potential to save LLCs thousands of dollars on self-employment taxes through their inherent recognition of LLC members as employees of the company. However, as will be discussed below, there is a time and place for businesses to elect this tax designation, and in some circumstances it is likely to be more beneficial for them to retain the standard LLC tax designation.
S-Corps also allow for efficient and simple transfers of ownership. This transfer can also be done with minimal tax implications and complications. As a result, S-Corps offer one of the most uncomplicated forms of transferring ownership.
Additionally, electing as an S-Corp can help businesses bolster their credibility and professionalism. This will ultimately improve relationships between partners, customers, suppliers, and employees in the long run. This is largely due to the credibility of the election, as well as the dedication and commitment that it shows.
Things To Consider
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The paramount idea an LLC should be considering is whether or not it is optimal for them to elect the S-Corp tax status. This decision depends on the leftover profit the LLC is looking at carrying over from one tax year to the next. LLCs that cannot accurately estimate how much profit they will make by the end of the year will be better off not electing S-Corp tax status.
For those that can safely assume their annual distribution will exceed $10,000 after its members have been paid a “reasonable salary”, it is worth considering the decision to elect S-Corp tax status. This decision hinges on an LLC having substantial distributions each year, which means an active decision not to invest these profits back in the business to promote growth. This can be a daunting task, but if the business has deemed the benefits and advantages as worth it, it is in their interest to invest in the S-Corp election.
Of course, this is not suited to every LLC’s situation. Indeed, particularly for small businesses, it is often preferable to remain as a default LLC so that as much of the business’s profits can be reinvested to generate growth. Furthermore, paying for the payroll and accounting services of a bookkeeper would likely yield a benefit outweighing the tax savings.
Closing Comment
The primary reason any LLC elects to become an S-Corp is to make tax savings, though even if the requirements to become an S-Corp are met, it is not always in the best interest of a business to choose this tax designation. Apart from the tax benefits of an S-Corp, there are a plethora of other benefits that need to be taken into account. Ultimately, a business should invest time and research into the process before committing to it. However, once a commitment has been made, business owners tend to see fruitful results for employees and shareholders alike. For information on how to start an s corp, The Really Useful Information Company (TRUiC) provides a great resource on the topic.
