Should You Make an S Election For Your Limited Liability Company?

by | Feb 1, 2021

A limited liability company (“LLC”) may elect to be taxed as a partnership, a C Corporation, an S Corporation, or as a disregarded entity.  Many LLCs elect to be treated as “S Corporations” for federal income tax purposes in order to minimize employment taxes.  Each owner of an LLC which is taxed as a partnership or as a disregarded entity is treated as being self-employed for tax purposes, and all amounts paid to such owners who also provide services, whether as compensation for services or as distributions, are subject to Social Security and Medicare taxes.  An owner of an LLC taxed as an S Corporation, however, can be treated as an employee of the LLC.  Thus, only his or her salary will be subject to Social Security and Medicare taxes, but any dividends received will not be subject to these taxes.

An S Corporation owner-employee, however, must pay him or herself a salary that is at least what other comparable businesses pay for similar services.  Moreover, in order to maximize contributions to retirement plans, it can be advantageous for an S Corporation to pay substantial salaries to its owner-employees.  As a result, the employment tax savings may not be significant.

Moreover, there are a number of drawbacks for a limited liability company being taxed as an S Corporation as opposed to being taxed as a partnership.  For example:

1. An S Corporation cannot have more than 100 shareholders. 

2. An S Corporation’s shareholders must be U.S. citizens or resident individuals, or certain types of trusts and tax-exempt organizations.  Thus, a partnership or corporation may not own an interest in an S Corporation. 

3. An S Corporation may have only common stock, which may be voting or non-voting.  S Corporations cannot issue preferred stock, profits-only interests, or stock with special allocations or changing profit sharing ratios.  This limits the LLC’s ability to raise capital from investors who expect a preferred return on their investment.

4. Service businesses may not often have the need to raise capital, but they often desire to provide key employees with an ownership interest in the business as a means of succession planning.  An S Corporation, however, cannot issue equity in the form of a so-called “profits-only interest” to an employee in exchange for the employee’s services, and any stock issuance to an employee will be taxable to the employee based on the fair market value of the equity interest issued. 

5. An S Corporation that was previously a C Corporation and that has earnings accumulated from its C Corporation years can have no more than 25% of its income from passive sources.  Passive income is income from an endeavor in which the company does not actively participate, such as investment income and most types of rental income.  The S Corporation will pay corporate tax on any passive income that exceeds 25% of its total income.  If more than 25% of its income is passive for three consecutive years, the company’s S Corporation status will terminate.

6. If the shareholders of an S Corporation decide that it would have been better to be taxed as a partnership, the LLC cannot change its tax status without being taxed as if it had sold all of its assets and dissolved.

In those cases in which the above limitations will not likely be meaningful, then self-employment tax savings may prove useful.  For example, an individual who provides consulting services through his single member LLC could elect S Corporation status for the LLC.  The company could pay him or her a modest salary which would be subject to applicable employment taxes, and have the remainder of the income paid as a dividend which would not be subject to any employment taxes.  If this business were conducted as a sole proprietorship or as a single member LLC taxable as a disregarded entity, all of the taxable income of the business would be subject to employment taxes. As noted above, salaries paid to S Corporation owners cannot be unreasonably low.

In our experience, some professional advisors tend to favor one form of taxation over the others without considering the LLC’s and its owner(s) needs in each case.  Choosing the best approach to income taxation, however, is not a “one size fits all” situation, and making the wrong choice can be both expensive and difficult to fix. 

For more information, please contact Len Gambino at Leonard.Gambino@SFBBG.com or call 312-648-2300.

A limited liability company (“LLC”) may elect to be taxed as a partnership, a C Corporation, an S Corporation, or as a disregarded entity.  Many LLCs elect to be treated as “S Corporations” for federal income tax purposes in order to minimize employment taxes.  Each owner of an LLC which is taxed as a partnership or as a disregarded entity is treated as being self-employed for tax purposes, and all amounts paid to such owners who also provide services, whether as compensation for services or as distributions, are subject to Social Security and Medicare taxes.  An owner of an LLC taxed as an S Corporation, however, can be treated as an employee of the LLC.  Thus, only his or her salary will be subject to Social Security and Medicare taxes, but any dividends received will not be subject to these taxes.

An S Corporation owner-employee, however, must pay him or herself a salary that is at least what other comparable businesses pay for similar services.  Moreover, in order to maximize contributions to retirement plans, it can be advantageous for an S Corporation to pay substantial salaries to its owner-employees.  As a result, the employment tax savings may not be significant.

Moreover, there are a number of drawbacks for a limited liability company being taxed as an S Corporation as opposed to being taxed as a partnership.  For example:

1. An S Corporation cannot have more than 100 shareholders. 

2. An S Corporation’s shareholders must be U.S. citizens or resident individuals, or certain types of trusts and tax-exempt organizations.  Thus, a partnership or corporation may not own an interest in an S Corporation. 

3. An S Corporation may have only common stock, which may be voting or non-voting.  S Corporations cannot issue preferred stock, profits-only interests, or stock with special allocations or changing profit sharing ratios.  This limits the LLC’s ability to raise capital from investors who expect a preferred return on their investment.

4. Service businesses may not often have the need to raise capital, but they often desire to provide key employees with an ownership interest in the business as a means of succession planning.  An S Corporation, however, cannot issue equity in the form of a so-called “profits-only interest” to an employee in exchange for the employee’s services, and any stock issuance to an employee will be taxable to the employee based on the fair market value of the equity interest issued. 

5. An S Corporation that was previously a C Corporation and that has earnings accumulated from its C Corporation years can have no more than 25% of its income from passive sources.  Passive income is income from an endeavor in which the company does not actively participate, such as investment income and most types of rental income.  The S Corporation will pay corporate tax on any passive income that exceeds 25% of its total income.  If more than 25% of its income is passive for three consecutive years, the company’s S Corporation status will terminate.

6. If the shareholders of an S Corporation decide that it would have been better to be taxed as a partnership, the LLC cannot change its tax status without being taxed as if it had sold all of its assets and dissolved.

In those cases in which the above limitations will not likely be meaningful, then self-employment tax savings may prove useful.  For example, an individual who provides consulting services through his single member LLC could elect S Corporation status for the LLC.  The company could pay him or her a modest salary which would be subject to applicable employment taxes, and have the remainder of the income paid as a dividend which would not be subject to any employment taxes.  If this business were conducted as a sole proprietorship or as a single member LLC taxable as a disregarded entity, all of the taxable income of the business would be subject to employment taxes. As noted above, salaries paid to S Corporation owners cannot be unreasonably low.

In our experience, some professional advisors tend to favor one form of taxation over the others without considering the LLC’s and its owner(s) needs in each case.  Choosing the best approach to income taxation, however, is not a “one size fits all” situation, and making the wrong choice can be both expensive and difficult to fix. 

For more information, please contact Len Gambino at Leonard.Gambino@SFBBG.com or call 312-648-2300.