Taking Advantage of the Magic of an S Corporation

Many small businesses start as sole proprietorships. As they grow, transitioning to an LLC is a common next step. This transition often occurs to bring in more capital or skills by adding members (owners) and/or to limit personal liability, protecting the owners’ assets. If the LLC fails or faces a significant lawsuit, the LLC's assets may be at risk, but the members’ personal assets remain protected as long as the LLC maintains corporate formalities and complies with its operating agreement.

However, as an LLC becomes more profitable, members may find themselves paying a hefty self-employment tax on the entire profit of the company. For example, with a net income of $400,000, members might face a self-employment tax bill of $61,000. Although members can pay themselves salaries (or guaranteed payments) to reduce the LLC’s profit, they still owe FICA or self-employment tax on the entire $400,000.

The Benefits of S Corp Status

The primary benefit of electing S Corp status is the reduction of self-employment tax paid by the owners (members). In an S Corp, instead of taking draws as they might in a proprietorship or LLC, members are paid a salary and receive a W-2. The only tax paid is on this salary.

This is where the “Magic” of an S Corporation comes into play. If the LLC meets certain criteria, filing one form with the IRS can save the members a big chunk of self-employment tax. This form allows the LLC to elect to be taxed as a Subchapter S Corporation, commonly known as an S Corp or Sub S Corporation.

Revisiting the example of an LLC with a sole member and a net profit of $400,000 owing $61,000 in self-employment tax, in an S Corp, the member would be paid a salary, say $100,000, resulting in $15,000 paid in FICA tax instead of self-employment tax.  That would reduce the net income to around $300,000, upon which no self-employment tax would be due. This approach saves $46,000 ($61,000 - $15,000).

Requirements for Electing S Corp Status:

1. Domestic Corporation: The LLC must be a domestic corporation.

2. Eligible Shareholders: Shareholders must be individuals, certain trusts, or estates. Shareholders cannot be partnerships, other corporations, or non-resident aliens.

3. Limit on Number of Shareholders: The corporation can have no more than 100 shareholders. Family members can be treated as a single shareholder for this purpose.

4. One Class of Stock: The corporation can only have one class of stock, meaning all shares must have identical rights to distribution and liquidation proceeds, although voting rights can vary.

5. Not an Ineligible Corporation: Certain corporations, such as banks using the reserve method for bad debts, insurance companies taxed under Subchapter L, possessions corporations, and domestic international sales corporations (DISCs), are ineligible.

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Conclusion

Electing S Corp status can offer significant tax savings for profitable LLCs. By structuring compensation as a salary, members can reduce their self-employment tax burden while still complying with IRS requirements. This strategic move can enhance financial efficiency and provide more resources for the continued growth and success of the business.