Should an LLC elect S corp taxation?

Profit and reasonable compensation

The idea behind most S corp advice is this: wages are subject to employment taxes, and the IRS describes non-wage distributions to shareholders as not subject to them. But the IRS also says an S corporation must pay a shareholder-employee reasonable compensation for their services before making non-wage distributions, and it has the authority to reclassify distributions as wages.

The IRS looks at where the business's money comes from. To the extent gross receipts come from the owner's personal services, payments to the owner should be wages. Receipts produced by non-owner employees or by capital and equipment can support distributions. Its factors include training and experience, duties, time devoted to the business, and what comparable businesses pay for similar services.

So the honest version: if most of the profit comes from your own work, much of what you take out may need to be wages anyway. How that comes out for you is a question for a CPA, working from your P&LP&L A profit and loss statement shows whether your business made money over a period of time, revenue at the top, costs beneath it, profit at the bottom., not a rule of thumb.

Payroll cost and administration

Paying yourself wages means running payroll: withholding income tax, paying Social Security, Medicare and federal unemployment taxes, making deposits on time, and filing employment tax returns such as Forms 941 and 940. You can do it yourself or pay someone to do it. Either way, it is a recurring cost in time or money, in good years and slow ones.

State taxes and state recognition

The federal election is only half the picture. States differ in how they tax LLCs and S corporations, and you can't assume your state follows the federal treatment. Check with your state's revenue agency, or ask your CPA what your state does with an S election, before you file.

Number and type of owners

An S corporation can have no more than 100 shareholders, and they generally must be individuals, certain trusts and estates, or certain tax-exempt organizations. Partnerships, corporations and nonresident aliens can't be shareholders. It can have only one class of stock, which generally means every share has identical rights to distributions and liquidation proceeds. Every shareholder must consent to the election.

For an LLC, the one-class rule matters for how money is split. If your operating agreement pays some members differently from their ownership share, raise it with your CPA and attorney before electing. And if you might add an owner who can't hold S corporation stock, the election may stop fitting.

Benefits and deductions

Some benefits work differently for an S corporation owner than for an ordinary employee. For example, the IRS says health and accident insurance premiums paid for a shareholder-employee who owns more than 2 percent are deductible by the S corporation and reported as wages on that owner's W-2, under special rules. Ask your CPA how each benefit and deduction you have now would be handled after an election. For what a deduction is actually worth, see write-offWrite-off A write-off is an ordinary and necessary business expense deducted from income, which reduces taxable profit. It does not make the purchase free..

Accounting and compliance costs

An S corporation files its own federal return, Form 1120-S, and gives each owner a Schedule K-1. Add payroll filings and any state filings. Monthly books stop being optional, because the return, the K-1s and the wage decision all come from them. If your books aren't closed every month yet, fix that first.

Distribution strategy

How and when owners take money out matters more after an election. Distributions come after reasonable wages, not instead of them. With more than one owner, the one-class-of-stock rule generally means distributions follow ownership.

Distributions are also not the same as spare cash. Keep enough cashCash flow Cash flow is where the cash actually went, money in and money out, in the order it happened. in the business for the next inventory buy, payroll and taxes before anyone takes a distribution.

Future ownership plans

If you expect to bring in investors, add an owner that is a company, create different classes of ownership, or sell the business, say so before electing. Those plans can conflict with S corporation eligibility. And it is not a switch you can flip back and forth. Once an election ends, the IRS generally must consent before the business can elect S status again before the fifth tax year.

How the election itself works

An eligible LLC elects by filing Form 2553, with every owner's consent. Filing it on time also makes the LLC a corporation for federal tax purposes, so it doesn't need a separate Form 8832. Form 2553 is generally due no more than 2 months and 15 days after the start of the tax year the election should take effect, or at any time during the year before. The IRS offers relief for late elections in some situations.