Starter Law 201: Should Your LLC Be Taxed as an S-Corp?

Why you probably DON'T want to make an S-election for your LLC

Andrew Fisher Andrew Fisher
Apr 20 · 5 min read
Sign, Harlingen, Texas.1939. Photographer Lee Russell
Note: This post is a part of our Starter Law 201 series, an exploration of advanced legal topics for business founders. You can find the full series for beginners, Starter Law 101, on our main blog page, here.

Congratulations! You’ve decided to start your own business. You’ve picked a name, designed the logo, maybe even started writing your business plan – all the fun stuff! Then you realized that you’d have to pick which type of legal entity to form, did some research, and decided that an LLC was right for you.

Not sure whether an LLC or corporation is right for you? Startomatic has you covered.

If you’re reading this, you've probably also heard that you have some options about how your LLC will be taxed. You may know that some LLCs that chose to be taxed as “S-corporations” in order to save money. You may be thinking that it was something you might want to do for your new LLC. You probably shouldn’t.

That’s right; most LLCs probably won’t save much – if any – money by making an S-election – or at least not enough to be worth the hassle of dealing with the S-election. Want to know why? Keep reading!

A refresher on legal entities

First, let's understand some basics about the two most common types of legal entities: corporations and limited liability companies (also known as LLCs). 
  • Corporations have a more complex management structure (read: more paperwork) than LLCs. They also typically have what is called "double taxation". While not exactly "double", a corporation that has not made an S-election does have two levels of taxation: first, the corporation pays taxes on its earnings, and second, its shareholders (owners) pay tax on any money the corporation distributes to them.
  • LLCs, on the other hand, combine the benefits of simplified management and "pass-through taxation". What in the heck is pass through taxation?  Simply put, it means the company itself doesn’t pay taxes; instead, the tax liability is “passed through” to the company owners, who pay taxes based on the amount of company income (or loss) that is allocated to them.

Key Takeaway: Corporations that have not made an S-election (known as "C-corporations) are subject to "double taxation". LLCs on the other hand enjoy "pass-through" taxation, with only the owners paying taxes.

How LLC owner/operators are usually taxed

If, like most LLC owners, you intend to work for your company – i.e., you’re not a passive investor – then you’ll typically have to pay self-employment taxes on the entire net income earned by the company. This means you’ll pay the full amount of FICA tax (Social Security and Medicare, 15.3% combined as of 2021) on the company’s net profits. Compare this to a typical employee, whose employer would pay half of those payroll taxes, meaning a potential savings of 7.65%.

Note: We’re only talking about federal taxes here. State-level employment and corporate income taxes will vary by state.

Key Takeaway: LLC owner/operators usually pay more in taxes than they would if they were making the same salary as employees of another company. 

How LLC owners choosing S-corp status are taxed

On the other hand, an LLC which makes the election to be taxed as an S-corporation can split its payments to owners into (a) salary subject to ordinary income and self-employment (the full 15.3% FICA) taxes, and (b) dividend income, which is taxed at 0%, 15% or 20%, depending on taxable income and filing status. For many taxpayers, the dividend tax rate will be lower than the ordinary income rate.

Result: tax savings equal to the difference between the ordinary income rate and the dividend rate – but only on the amount distributed as dividends.

Key Takeaway: Profits you take out of your LLC in the form of dividends will usually be taxed at lower rates than profits you take as salary. However, you can only take money out of your LLC as dividends if the LLC chooses to be taxed as an S-corporation.

So... why wouldn’t every LLC choose S-corporation taxation?

We can hear you now: “That’s great! I’ll make the s-election and save a lot of taxes by taking a $100 annual salary from my LLC and distributing the rest of the company's profits as dividends, since they're taxed at a lower rate.”

But hold on there – did you really think the good ol’ IRS was going to let you get away with that? They don’t, and that's just one of three problems:

First, the IRS requires that the salary that you take be reasonable, based on factors like what other businesses pay for similar services, your training and experience, and what you pay to non-owner employees. So that $100 annual salary is a non-starter.

Second, LLCs (or corporations) taxed as S-corps are subject to a number of limitations:
  • All owners must be individuals (not companies or other entities) and must be U.S. citizens or resident aliens,
  • There is a maximum of 100 owners, and
  • The company may have only one class of equity (no preferred returns or other distinct ownership features).

Third, an LLC choosing to be taxed as an S-corporation is required to file its own tax return every year, even though it's not paying taxes directly.  For most people, this means paying a CPA a few hundred dollars or more to prepare and file Form 1120S every year.

Key Takeaways: The amount of money you can save in taxes by electing S-corporation status for your LLC is limited by IRS rules. Whether the amount you'll save is worth the additional costs, additional paperwork, and restrictions on the LLC's ownership, can be difficult to determine.

The bottom line

If you expect that your LLC will have significant income and will meet the IRS's limitations for S-corporation ownership, AND you have a good understanding of corporate taxes and your own tax rates, it may save you money to make an S-election for your company.

BUT, before you do, we recommend you speak with a tax professional who is experienced in small business taxes, and have them run some numbers to be sure you're making an informed choice.

If you're sure you want to file an S-election for your LLC...

We have good news for you: Startomatic makes it super simple.

Our S-Election Application completely automates the preparation and filing of your Form 2553. No papers to print or sign, and no extra cost - that's right, it's 100% included in your Startomatic subscription.

Want to learn more or subscribe to Startomatic's suite of practical tools for business founders and owners? Check out everything we offer, right here.
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