LLC Taxed As S Corp: How To Make the Election + One BIG MISTAKE to Avoid!Business Taxes
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Electing for your business to be taxed as an S corporation may offer you tax savings on Social Security and Medicare taxes.
Perhaps the easiest way for a new business to be taxed as an S corporation is for the owner(s) to form an LLC for their business with their state’s secretary of state and then for this LLC to file Form 2553 with the Internal Revenue Service (IRS) as well as, if required by their state, any state S corporation paperwork with their state’s revenue department.
However, if business owners go this route for electing S corporation status for their business, they should be aware of a major pitfall that could completely invalidate their S corporation election.
Learn how an LLC can be taxed as an S corporation and what business owners considering this move should watch out for.
Want to learn more basics about S corporations? Watch the video below or read this article!
How LLCs Are Taxed by Default
How an LLC is taxed by default depends on whether it’s a single-member LLC or a multi-member LLC.
LLC owners are called “members,” so a single-member LLC only has one owner.
Single-member LLCs are “disregarded entities” for federal income tax purposes, meaning that the IRS essentially ignores the LLC for income tax purposes.
This means that the single-member LLC’s owner reports the LLC’s income, deductions, and other tax items on their own tax return as though the LLC did not exist.
Multi-member LLCs have more than one owner and are taxed as a partnership by default.
This means they must file Form 1065 with the IRS and issue Schedule K-1s to all members of the LLC.
|Has one and only one owner||Has more than one owner|
|Ignored for federal income tax purposes by default||Taxed as a partnership by default|
|Does not file a federal income tax return with the IRS||Files Form 1065 with the IRS|
|May be liable for state taxes and fees, depending on the state||May be liable for state taxes and fees, depending on the state|
|May have to file a state tax return||Must file a state partnership tax return|
Should You Elect S Corp Status For Your LLC?
Electing S corporation status may — or may not — provide tax benefits for you.
Although this article gives a more complete picture of the advantages and disadvantages of electing S corporation status for your business, here are some of the major pros and cons.
LLC Taxed As S Corp Pros
- Potential Tax Savings: Forming an S corporation could save you money on Social Security and Medicare taxes. Here’s an example how.
- Possibly Less Audit Risk: S corporation returns (Form 1120S) are audited at a lower risk than Schedule Cs.
LLC Taxed as S Corp Cons
- More Complex Tax Situation: Since S corporations are required to file their own tax return(s), they naturally increase the complexity of their owners’ tax situation.
- More Administrative Fees: Setting up an S corporation means more administrative fees such as payroll costs and annual secretary of state filing fees.
Read this article for more information about the pros and cons of S corporations in general.
S Corporations Are Not Legal Entities.
S corporations are a creation of Internal Revenue Code § 1362. For legal purposes, however, your LLC is still an LLC. Making an S corporation election only has ramifications in the world of income taxes!
How to Elect S Corp Status For an LLC (Step-by-Step)
Here’s how to elect S corporation status for an LLC in just a few steps.
Step 1: If you haven’t already, form your LLC.
State-by-state rules vary here, but check out this article for the general steps.
Step 2: File Form 2553 and any required state forms.
The next step is to file Form 2553 with the IRS no later than two months and 15 days from the beginning of the tax year you want your S corporation election to be effective for. If you miss this deadline, late S corporation election relief is available.
Note that your LLC may, optionally, file Form 8832 prior to filing Form 2553 in order to first elect to be taxed as a corporation.
However, this is not necessary because according to Treasury Regulations § 301.7701-3(c)(1)(v)(C), an entity (such as an LLC) that makes a valid, timely-filed S corporation election is automatically deemed to have elected to be taxed as a corporation on the effective date of its S corporation election.
Read this article to learn more about filing Form 2553.
Step 3: File your state S corporation election (certain states only).
If your state is one of the few states that requires a separate S corporation election, you will need to file an S corporation election with your state as well.
Step 4: Set up payroll.
If you are working in your business day in and day out, your S corporation will have to pay you a reasonable salary.
This means you will have to set up payroll for your S corporation.
You could, of course, do this by hand or pay a local tax professional, but I personally use Gusto to handle my own S corporation’s payroll.
Step 5: Look out for the CP261 Notice.
CP261 is the approval notice that the IRS will send your LLC to notify it that it has approved its S corporation election.
Once you receive this notice, save it in your files.
I would recommend scanning it and keeping an electronic backup as well.
A Major Pitfall in Your LLC Operating Agreement
Many business owners who elect for their LLC to be taxed as an S corporation make a big mistake when it comes to their LLC’s operating agreement — especially if they draft their own operating agreement or use boilerplate language they found online.
However, some language in an LLC’s operating agreement could cause the IRS to invalidate the LLC’s S corporation election — if the IRS finds out about it, of course.
The kind of language I’m talking about is language that could be interpreting to imply that the LLC has multiple classes of stock.
See, one of the S corporation requirements is that the business entity has only one class of stock.
So if an LLC operating agreement, say, references any kind of disproportionate distributions to LLC members or special classes of LLC shares, that could cause the LLC’s S corporation to become invalidated.
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.