An LLC is a company; an S corp is a tax status
An LLC is a business structure you create by filing articles of organization with a state. S corporation status is a federal tax treatment: a corporation, or an LLC eligible to be taxed as one, elects it by filing Form 2553 with the IRS. So the real choice is between an LLC taxed the default way and the same LLC taxed as an S corporation.
How each is taxed
| LLC, default tax treatment | LLC taxed as an S corporation | |
|---|---|---|
| Income tax | Profit passes through to the members' own returns: Schedule C for a one-member LLC, a partnership return and members' shares for two or more | Profit passes through to the owners' own returns, reported on an S corporation return |
| Self-employment tax | Members who work in it generally pay it on their share of net earnings: 15.3% for Social Security and Medicare | Owners who work in it are paid wages, with payroll taxes on those wages; other profit paid out isn't wages |
| Owner's pay | Draws from profit, no payroll | A reasonable salary through payroll, then distributions |
| Who can own it | Anyone, any number | No more than 100 owners, all individuals, certain trusts or estates |
| Yearly federal filings | Schedule C, or a partnership return | An S corporation return, quarterly payroll returns and W-2s |
The difference that draws owners to the election is self-employment tax. Under the default treatment, a working owner pays it on all of the business's net earnings from self-employment. As an S corporation, the business pays the owner a salary, with Social Security and Medicare taxes withheld and matched as for any employee, and the profit left over can be distributed without those taxes.
The salary has to be reasonable
The IRS requires an S corporation to pay a shareholder who works for it reasonable compensation for those services before it makes non-wage distributions to that shareholder. An owner who pays themselves a token salary and takes the rest as distributions invites the IRS to reclassify the distributions as wages. A reasonable salary is roughly what the business would pay someone else to do the owner's job.
Who can elect
The IRS's tests for S corporation status:
- a domestic corporation, or a domestic entity, such as an LLC, eligible to be taxed as one;
- only allowable shareholders: individuals, certain trusts and estates, and no partnerships, corporations or nonresident aliens;
- no more than 100 shareholders;
- only one class of stock;
- not an ineligible corporation, such as certain financial institutions and insurance companies.
An LLC with a corporation or a foreign investor among its members can't elect, and neither can one whose operating agreement gives members different rights to distributions, which would amount to a second class of stock.
How and when to file Form 2553
Every shareholder signs Form 2553, Election by a Small Business Corporation. It's due no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the year before. An LLC that files it is treated as a corporation from the election's effective date and doesn't need to file Form 8832 as well. The IRS has relief for an election filed late with reasonable cause.
When the election tends to make sense
The election saves self-employment tax only on the profit left after a reasonable salary, and it costs money to keep: payroll each pay period, a separate corporate return, and in some states a tax of their own on S corporations. It tends to pay off for an owner who works in a business with steady profit well above what a reasonable salary for their work would be, and rarely in a business's first lean years. A tax professional can run the numbers for your business before you file.
What doesn't change
The election is federal tax treatment only. Under state law the business is still an LLC: the same name on the register, the same annual report, the same operating agreement and the same liability shield. You can revoke the election later, but electing again within five years generally takes the IRS's consent.
Sources
- S corporations, IRS
- Instructions for Form 2553, IRS
- S corporation compensation and medical insurance issues, IRS
- Limited liability company (LLC), IRS
- Self-employment tax (Social Security and Medicare taxes), IRS
Common questions
Is an S corp better than an LLC?
They aren't alternatives: an LLC can be taxed as an S corp. The question is whether your LLC should elect S corporation status, which can lower self-employment tax for an owner who works in a profitable business, at the cost of running payroll and filing a corporate return.
How does an LLC become an S corp?
By filing IRS Form 2553, signed by every member, no more than 2 months and 15 days after the start of the tax year the election should take effect, or at any time in the year before. An eligible LLC that files it is treated as a corporation from that date and doesn't need to file Form 8832 as well.
Can any LLC elect S corp status?
Only if it meets the IRS's tests: no more than 100 owners, all of them individuals, certain trusts or estates (no partnerships, corporations or nonresident aliens), and only one class of ownership.
Do I have to pay myself a salary in an S corp?
If you work in the business, yes. The IRS requires an S corporation to pay a shareholder who works for it reasonable compensation for those services before it makes other distributions to that shareholder.
Does an S corp election change my LLC with the state?
No. The LLC stays an LLC under state law, with the same name, filings and liability shield. The election changes only how the IRS taxes it, though some states tax S corporations in their own way.