LLC taxed as S Corp: pros and cons, and benefits

An LLC taxed as S Corp has some benefits but also has disadvantages to the company. This happens when it elects the tax status of an S Corp. Certain criteria must be met for LLC to be taxed as an S Corp.

Advantage of LLC taxed as S Corp

One of the main advantages of having an LLC taxed as S Corp is that it protects one’s personal assets from business liabilities. However, this protection comes at a cost and unless you add new members to your LLC, there is no membership continuity after you die or retire so your family members cannot step into your shoes and carry on managing your business. You have to transfer your LLC ownership just like you had bought it from the previous owner/member.

For example, if you are an individual with 100% interest in an LLC which is set up as a disregarded entity for US federal tax purposes (single member LLC) and you die or become unable to manage your business, your LLC will be automatically terminated and you would have to liquidate it unless you transfer ownership to someone else.

This might not be the best choice if you are planning for your family to take over your business after you retire or pass away. As a result, let’s consider how this could affect small businesses with multiple owners (family members)

Which is better? LLC taxed as S Corp or LLC taxed as Partnership?

  1. If you have only one owner in your business and the other family member(s) are looking for a future retirement or to take over your business after you pass away, an S-Corp structure is probably a better choice because there would be no membership continuity after your death. In this case, 100% of the net income would be subject to tax at individual rates, but your family will have a better chance of receiving the money after it is transferred to them without going through the liquidation process.
  2. If you have multiple owners in your business and want to build up capital for your retirement or future succession of the family business, an LLC taxed as partnership might be a better choice because it will provide pass-through tax treatment for all partners, thus preserving the accumulated capital. In most cases, this is probably the best option if one wants to transfer ownership of LLC to family members after retirement or passing away.
  3. If you have multiple owners in your business and want to preserve accumulated capital for future growth, an LLC taxed as partnership might be a better choice because it will provide pass-through tax treatment for all partners, thus preserving the accumulated capital.
  4. If you have multiple owners in your business and want to ensure that each family member has his or her own retirement account, regardless of whether they are active in the business or not, an LLC taxed as S Corp might be a better choice. In this case, an S-Corp can have two types of stock: voting and nonvoting.
  5. When you have multiple owners in your business and want to easily transfer ownership to your children after you retire or pass away, an LLC taxed as S Corp structure might be the best choice because all family members can own voting stock. If they want to take over the business, they will not need to buy out other owners.
  6. If you have a husband and wife as owners in your business, an LLC taxed as partnership might be the best choice because they will only need to file a single tax return for the business under their married Filing Jointly status. The S-Corp structure is not able to offer this filing status and would require them to file as single if they opt for the S-Corp status. This might not be the best choice if you want to maximize tax deductions and credits, such as depreciation and medical expense deductions and child and dependent care tax credit because these benefits are limited under this filing status.
  7. If you have a husband and wife as owners in your business, an LLC taxed as S Corp structure might be the best choice because they can each have their own retirement accounts. They can either set up their own SEP IRA plans or have to use the Solo 401k plan offered by many financial institutions for this purpose.
  8. If you have a husband and wife as owners in your business, an LLC taxed as S-Corp structure might be the best choice because they can each have their own medical insurance plan by using their respective self-employed health insurance deduction.
  9. If you want to maximize the depreciation and medical expense deductions and child and dependent care tax credit, an S-Corp structure might be your best choice, as it is the only business type that has this benefit at the moment. The LLC taxed as partnership is not able to offer different classes of stock to its members as it has only one class.
  10. If you want to use the cash method of accounting, an S-Corp structure might be your best choice because this business type is required to use the accrual basis of accounting.
  11. If you want to defer income to later years, an S-Corp structure might be your best choice. The LLC taxed as partnership can only allow this if it is run by a husband and wife or family members that reside at the same address.
  12. If you need outside investors in your business, an LLC taxed as S Corp might be your best choice. The LLC taxed as partnership is not able to offer different classes of stock to its members as it has only one class. This business structure would require you to sell shares of your company to the outside investors, which might be more costly than receiving a loan from an investor under certain conditions.
  13. If you need debt financing in your business, an LLC taxed as S Corp structure might be your best choice because the lenders prefer to lend money to this business structure for its limited liability purpose.
  14. When you want to use research and development credits, an LLC taxed as S Corp structure might be your best choice because this business type is required to use the accrual basis of accounting.
  15. If you want to have a retirement plan for your owners, an LLC taxed as S Corp might be your best choice. The LLC taxed as partnership is not able to offer different classes of stock to its members as it has only one class. The owners have to use a SEP IRA or a Solo 401k plan for this purpose.
  16. If you want the business owner(s) to receive a draw from the business, an S-Corp might be your best choice.
  17. When you want the business owner(s) to receive a salary from the business, an S-Corp might be your best choice because this business structure has more flexibility for paying salaries and bonuses (under certain circumstances) than the LLC taxed as partnership.
  18. In order to take advantage of the current tax deduction for hiring veterans, an S-Corp might be your best choice.
  19. If you want family members in your business, an S-Corp might be your best choice. The LLC taxed as partnership is not able to offer different classes of stock to its members as it has only one class.
  20. If you want to change managers for the business (e.g., if someone retires), an LLC taxed as S Corp might be your best choice because this business type is required to use the accrual basis of accounting for tax purposes.
  21. If you want to pay state taxes, an S-Corp might be your best choice because this business structure can choose an “election out” in most cases and avoid double taxation on its state level. An LLC taxed as partnership might be required to pay state taxes in some states even if it is an “S-Corp” for federal taxes.
  22. If you want to close your business, an LLC taxed as S Corp is generally better than the LLC taxed as partnership. This is because the IRS charges a fee to audit a business and if an S-Corp converts to another business type, it does not have to pay this fee for the prior years as long as the conversion is done before the end of the fiscal year. In most cases, an LLC can only elect into being taxed as an S-Corp by filing a form with the IRS after the first year of business.
  23. If you want to “cash out” or sell your ownership interest in the business, an S-Corp might be your best choice because this business type can distribute profits as salaries and bonuses (under certain circumstances). An LLC taxed as partnership cannot do so without being double taxed for going out of business.
  24. When you want your business to have a non-compete clause or other reason to limit distributions from the company, an LLC taxed as partnership might be your best choice because this business type is required to pay taxes on its income regardless of how it has been distributed. An S-Corp can only distribute profits in ways that are reasonable and can pay taxes when the business has profits.
  25. If you plan to work in your own business, an LLC taxed as partnership might be your best choice because this provides much better protection against lawsuits than an S-Corp structure. An S-Corp can provide limited liability to its members but not all employees are allowed to have member status or receive stock in the business.
  26. If you want to avoid having limited liability, an LLC taxed as partnership might be your best choice because this can protect its owners from being personally responsible for many types of claims against the company’s debts or liabilities. An S-Corp does not provide its members with limited liability except under very specific circumstances.
LLC taxed as S Corp comes with some benefits and drawbacks
LLC taxed as S Corp comes with some benefits and drawbacks

How is an LLC taxed as S Corp?

An LLC taxed as S Corp is a business structure that can be used to reduce self-employment taxes because the owner only pays social security and Medicare taxes on salary instead of having to pay those plus a share of profits. In an LLC, income and losses are “passed through” the business to each owner’s individual tax return, rather than being taxed at the business level. Since S Corp profits are taxed only once, at the owner’s individual tax rates and not that of the corporation (which is typically much higher), setting up an LLC taxed as an S Corp can be a smart move.

By default, all owners of an LLC will be subject to self-employment taxes including social security and Medicare taxes. However, if an LLC is taxed as an S Corp then it can avoid that second level of taxation and pass through its income or losses to the owners’ individual tax returns just like a partnership or sole proprietorship. The business will still be subject to federal and state corporate taxes, but profits will only be taxed at the owner’s individual tax rates, which are typically lower than the corporate tax rate.

Filing Requirements for an LLC taxed as S Corp

In order to be taxed as an S Corp, an LLC must have a single owner and be a domestic US company. It cannot have foreign owners or include corporations as members. The business must also meet all of the requirements for being taxed as a corporation. In addition, the single owner must have an IRS Employer Identification Number (EIN) and comply with all S Corp regulations.

An LLC electing to be taxed as an S corporation is subject to the substantial presence test if it has more than one member or readily-tradeable ownership interests. A single-member LLC is not subject to the substantial presence test if the LLC was formed in a foreign country.

An LLC electing S corporation tax status is also exempt from taxation on flow-through income if it has only one class of stock, which may be common or preferred, and that class has only one round lot (100 shares) outstanding.

However, LLCs taxed as an S corp are generally limited to 100 shareholders before they are considered publicly held corporations for SEC filing purposes. If shareholders are added beyond this number, the LLC must register with state authorities as a public corporation. A new election must occur with the IRS to be treated as an S corp at that point.

Why would an LLC elect to be taxed as an S corp?

LLCs would elect to be taxed as S Corps because of the fact that they provide their owners with limited liability and also provides some tax benefits. Therefore, this means that if a business fails it cannot be pursued by its creditors for the debts of the business; there are some tax benefits that might become available to LLCs that elect to be taxed as S Corps.

Filing for setting up an LLC taxed as S Corp

To set up your LLC taxed as an S Corp, you will need to file IRS Form 2553 with the Internal Revenue Service (IRS). This form is not filed at any local level; it is only submitted to the IRS. The form is sometimes not accepted by the IRS for technical reasons, in which case you can file Special Form 8832 after having already filed 2553.

S Corp taxes are due on or before the 15th day of the 4th month after your company’s tax year ends (March 15 for calendar-year companies). If you do not file and pay your taxes by the due date, you will owe a penalty.

The disadvantage of an LLC taxed as S corp

One drawback of being taxed as an S Corp is that you are limited in how much money can be deducted for business expenses. You may have to include some salary payments as income even if they were billed as an expense before being paid so keep this in mind when setting your salary.

Having known the pros and cons of LLC taxed as S corp, you can now make a choice whether such an action is good for you or not.