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Limited liability companies (LLCs) operate as sole proprietorships or partnerships. Thus, their owners are liable to pay self-employment taxes. However, becoming an S corporation can enable the owners to reduce their overall tax bill. What do you need to know?
Self-employment tax on sole proprietorship and partnership LLC
An LLC is only a "pass-through entity" but not an independent tax entity. Thus, the IRS considers the owners (members) of the LLCs liable for taxes. The liability comes from the profits and losses of LLCs pass on to their owners.
Even if you, as the owner of the LLC, keep the profits for the future development of your LLC, you have to pay an income tax on the retained profits. It is an IRS tax requirement.
If your LLC belongs to a single owner, then it is a sole proprietorship in the eyes of the IRS. You are required to complete SCHEDULE C with the businesses profits and losses included on your personal return.
If you own an LLC jointly with another person or more people, then it is a partnership by default. Each partner has to pay taxes on their share of the profits of the partnership. The partnership is required to file its own tax return 1065. The partnership itself does not pay income taxes. The partnership issues K-1s to the partners based on their profits and the partners pay taxes personally on behalf of the company.
In partnership LLCs, your share of profit depends on the operating agreement of your LLC. However, the common profit ratio is proportional to the business interest percentage of each member.
As a member of partnership LLCs, you are liable to pay your income tax despite not receiving the profit. The IRS deems unreceived profit as retained profit for the future development of co-owned LLCs.
Even though co-owned LLCs are not separate tax entities, they have to file the 1065 form with the IRS. The form is the one that a normal partnership files. It seeks to ensure that all members report their profits accurately. The entities also have to file Schedule K-1 for each member.
If you want to save money, then you can propose electing your single member LLC or multi-member LLC be taxed as an S corporation. Thus, your entity will become an independent tax entity.
Definition of an S corporation
Similar to a partnership return described above, an S corporation passes its income, credits, losses, and deductions to its shareholders and the company doesn’t actually pay any taxes. Afterward, the shareholders file personal tax returns and the IRS applies a personal tax rate to determine the payable tax. Thus, becoming an S corporation prevents double taxation that standard C Corporations are subject.
As partners of an LCC, you will enjoy the benefits of incorporation and keep your partnership rights.
Benefits of becoming an S corp
After becoming an S corp, your LLC will increase its credibility in the eyes of your customers, suppliers, lending institutions, investors, and employees. The stakeholders realize that the members of your entity have become more committed to the welfare of the entity.
Unlike in a partnership where the owners' assets are unsecured, becoming an S corporation protects the owners' assets from creditors' business claims.
Your entity will also get relief from paying federal taxes. The move will save money that the entity can use for more development, especially at the establishment level.
In an S corporation, you can transfer your interest with no adverse tax consequences. You will also get relief from adjusting the property basis and complying with hard accounting rules.
As a shareholder, you can also become an employee of your corporation. Thus, your income channels will increase.
You will also receive tax-free dividends as a shareholder of the entity. However, the distribution should not surpass your stock basis. If the distribution exceeds the stock basis, then you will pay capital gains tax.
The treatment of owners compensation in the form of distributions/dividends reduces the level of the self-employment tax. Thus, you end up paying a reduced amount of personal tax.
It’s important to note that LLCs taxed as S Corporations are not subject to self-employment taxes the way single member LLCs and multi-member LLCs (partnerships) are.
How to become an S corp
There are certain requirements that your LLC should meet to become an S corp:
- Need to have less than 100 shareholders.
- Your corporation should be domestic.
- The shareholders should comprise individuals, estates, and certain trusts only. Corporations, partnerships, and non-resident shareholders are not allowable.
- The entity should have only one class of stock.
- Your corporation should not be ineligible. Thus, it should not belong to certain financial institutions, and insurance companies, among other ineligible corporations.
To become an S corp, your LLC should file form 2553 that shows the election that a small business corporation makes. The form shows where to file the form depending on the location of the principal office of the entity. The form also details other instructions on how and when to file it.
However, note that an S corp is just a tax status and not an operational status. So, the members of your LLC remain as partners even though the entity assumes new tax filing requirements.
To optimize your income from an S corp, the IRS requires you to take a “reasonable salary” from the business and not take all of your compensation as tax free distributions. Reach out to AccountedFor for help converting your LLC to an S corp and pay less in taxes.