What are the benefits of single member LLC electing S Corporation Tax Status?

What are the benefits of single member LLC electing S Corporation Tax Status?
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A single member LLC by default is taxed as a sole proprietorship.  However, LLCs may choose to be taxed as S corporations by filing a from with the IRS, referred to as an “election”.  Read on to find out the potential tax benefits of making this election.

Disregarded Entities

The IRS refers to single member LLCs as “disregarded entities” for taxation purposes.  
 
This means that the profits and losses from an LLC are reported on schedule C of a 1040 individual tax return. This makes filing taxes easier, because single member LLCs taxed as disregarded entities do not have to file separate business tax returns like corporations and partnerships.
 
Although the tax filing is easier, it doesn’t mean it’s the most tax efficient way to file.

What is an S Corporation?

An S corporation isn’t a type of legal business entity like an LLC, corporation, or partnership.  Instead, an S corporation is a tax status recognized by the IRS.
 
When an LLC makes the election with the IRS to be treated as an S corporation, the legal status of the LLC doesn’t change.  The business structure is still an LLC.  The S corporation election with the IRS only affects the LLC’s tax filing requirements.

What are Self-Employment Taxes

Self-employment taxes consist of Social Security and Medicare taxes on your wages.  Income treated as dividends is generally not subject to self-employment taxes.  We will see why this matters below.
 
The self-employment tax rate is 15.3%, which consists of two parts: 12.4% for Social Security and 2.9% for Medicare.  For 2022, only the first $147,000 of wages are subject to the 12.4% Social Security tax while the Medicare tax has no limit, meaning all your wages are subject to the 2.9% tax.
 
With an S corporation, only amounts paid as W-2 income are subject to self-employment taxes, whereas with a single member LLC, your entire income is subject to self-employment taxes.   
 
S corporation earnings not paid as W-2 income are treated as shareholder dividends reported on Schedule K-1, which generally are not subject to self-employment taxes.  This allows an S corporation owner to take money out of the business and not be subject to the 15.3% self-employment taxes.
 
Note that self-employment taxes are taxes on wages, which are in addition to Federal income taxes.  All business are liable for Federal income taxes on earnings while self-employment taxes are only levied on amounts paid as wages. 

The Reasonable Salary Requirement by the IRS

S corporation income can either be salary (W-2 income) or dividends (K-1 income).  The salary portion is what is subject to self-employment taxes of 15.3%.
 
An owner/employee of an S corporation must pay themselves a “reasonable salary”, meaning that all the business income cannot be considered dividends.
 
For example, if you own a landscaping company that earns $100,000 in net profit, you cannot pay yourself a $100,000 “dividend” and avoid paying self-employment taxes on the entire amount.  You must pay yourself a reasonable salary or the IRS will come knocking.
 
There are no specific IRS guidelines for what constitutes a reasonable salary.  Instead, various courts have ruled on this issue.  Some factors considered by the courts in determining reasonable compensation include:

•  Training and experience 
•  Duties and responsibilities 
•  Time and effort devoted to the business 
•  Dividend history 
•  Payments to non-shareholder employees 
•  Timing and manner of paying bonuses to key people 
•  What comparable businesses pay for similar services
•  Compensation agreements 
•  The use of a formula to determine compensation 

LLC vs S Corporation Tax Benefits

By default, a single member LLC it is treated as a sole proprietorship for tax purposes.  This means it will report all income on schedule C of an individual 1040 tax return and be subject to self-employment taxes on the full amount of income.
 
On the other hand, the amount of self-employment tax an S corporation must pay is based on the amount it pays as W-2 income.
 
For example, let’s assume your LLC earns $100,000.
 
When taxed as a sole proprietorship, an LLC is responsible for paying $15,300 in self-employment taxes. ($100,000 times 15.3%)
 
On the other hand, if an S corporation pays its owner $60,000 as a “reasonable salary”, it is only liable for $9,180 in self-employment taxes. ($60,000 times 15.3%)
 
This results in a savings of $6,120 in total self-employment taxes paid.

LLC vs S Corporation Self-Employment Tax Comparison

​Note that the entire $100,000 is subject to Federal income taxes regardless of LLC or S Corporation status. 
 
The remaining $40,000 can either be kept in the business or paid out as a dividend.  Any amounts paid as a dividend will not be subject to the 15.3% self-employment tax.

How an LLC makes an S Corporation Election?

For a single member LLC to be taxed as an S corporation, an election with the IRS must be made.  This is done by filling out Form 2553, Election by a Small Business Corporation.  

IRS Form 2553

Your business may qualify only if it has:

• No more than 100 shareholders
• No nonresident alien shareholders 
• Only one class of stock

 
There are further instructions and requirements which can be read here.

Additional Costs of S Corporation Election

Electing S corporation tax status may come with additional costs and tasks including:
 

• Payroll provider, tax filings, etc.
• Additional tax return (1120s)
• Additional bookkeeping costs

 
It is important to weigh these additional costs when determining if S corporation status is right for you.
 
If you have any additional questions, please contact me here.