Taxing Your LLC as an S Corporation – Thinking it Through
March 10, 2020
You’re about to start a business, or perhaps you have an existing business organized as a limited liability company (“LLC”). You hear that you can save on taxes by being an S corporation, and who wouldn’t want that? But this is a decision with some far-reaching implications, and it deserves consideration of more than just the tax perspective.
To start, let’s clear up two common points of confusion. First, the IRS generally taxes entities as either corporations, partnerships, or S corporations. One may notice that “LLC” is not on that list. LLCs are, by default, taxed the same way as partnerships, though elections can generally be filed with the IRS to tax an LLC as one of the other types.
Second, and related to the first, an S corporation is not a type of entity that can be formed under state law. S corporation status only tells you how the business is treated for federal income tax purposes (and certain state and local income tax purposes), but doesn’t tell you much else. Assuming it meets the requirements of S corporation status, a corporation can file an election with the IRS to be taxed as an S corporation. Similarly, an LLC that meets the requirements for S corporation status can elect with the IRS to be treated like a C corporation, then make an additional election with the IRS to be taxed as an S corporation.
The Good – The Potential Tax Benefits
Both LLCs taxed as partnerships and S corporations are flow-through entities – that is, they generally don’t pay tax themselves, and instead all of the taxable income and loss is divided up between the owners, appearing directly on the owners’ tax returns. (Corporations, sometimes called “C corporations,” in contrast, do pay tax, which results in the oft-dreaded “double tax” – one level of tax paid by the corporation, and one level paid by shareholders when dividends are made.)
Although both LLCs and S corporations are flow-through entities, there are tax and non-tax differences. The most commonly touted tax benefit of S corporations over LLCs is the self-employment tax savings. Self-employment tax is generally levied on 100% of the distributions of an LLC to its owners who are active in the business. In contrast, S corporations can pay its owners a reasonable salary, which is subject to self-employment tax, while any remaining distribution from the S corporation is not subject to self-employment tax. Of course, this benefit only exists if the S corporation generates enough taxable income to pay a reasonable salary while having significant taxable income left over.
In addition, under the 2017 Tax Cuts and Jobs Act, individuals can potentially take a 20% deduction on qualified business income earned through LLCs and S corporations. For individuals who have higher incomes, that deduction can be reduced or eliminated if the business pays too little in W-2 wages. Wages that S corporations pay to its owners are taken into account (thereby potentially avoiding the limitation on the deduction), but wages that LLCs pay to its owners are not. In theory, then, electing S corporation status can provide flexibility in maximizing the available deduction by allowing wage payments to be adjusted.
The benefit of this structuring, however, may be limited. The law providing for this deduction is set to expire after 2025. S corporations engaged in certain types of businesses are not eligible for the deduction. Also, there is no benefit if the entity is already paying sufficient W-2 wages to other employees.
The Not So Good – The Limitations
One class of stock and pro rata distributions. S corporations are subject to a variety of limitations that LLCs are not. S corporations can have only one class of stock and must make all distributions pro rata, which means that the only economic difference between owners is what percentage of the company they own. A 30% owner would get 30% of all allocations of profits and loss, and 30% of all distributions. LLCs, on the other hand, have far more flexibility in structuring allocations and distributions.
Restrictions on who can be an owner. S corporation owners are limited to U.S. individuals, certain trusts, and tax-exempt organizations. Corporations, LLCs and foreign individuals are prohibited from owning S corporation stock. This can make it difficult to raise capital from investors (though not impossible, with substantial restructuring).
“Fragile” election status. To be taxed as an S corporation, an entity that would otherwise be taxed as a C corporation has to make an affirmative election with the IRS. Losing S corporation status, by contrast, can happen instantly and inadvertently, by running afoul of any of the requirements to be an S corporation (e.g., transferring S corporation stock to a corporation or ineligible trust). That also means that the entity may have to go back and treat itself like a regular corporation for past years, including paying the additional layer of tax (though the IRS has become increasingly tolerant of “foot faults” and allowing S corporations to retain their status).
Potential for gain on contributions and distributions. To contribute property to an S corporation without recognizing gain on that property, the contributors have to own 80% or more of the S corporation after the contribution. With respect to distributions, gain will generally be recognized on any distribution of appreciated property. In contrast, property generally can be contributed to and distributed from an LLC without incurring tax, making it much easier to move property into and out of LLCs.
Hard to undo. Making the election to go from LLC to S corporation is relatively simple and generally tax-free. However, if you change your mind and want to go the other way, from S corporation to LLC, there will be a deemed taxable liquidation of the S corporation that will generally cause all gain in assets to be recognized.
Less flexibility to achieve asset step up in basis on sale. Owners of S corporations contemplating a sale can, in general, sell the assets of the S corporation or sell the stock of the S corporation itself. Buyers typically prefer to purchase assets and get a step up in the tax basis of those assets, while sellers typically prefer to sell stock. There are special income tax elections available that allow a buyer to treat the purchase as a purchase of assets, giving the buyer a step up in asset basis, which in many cases is a “best of both worlds” situation for buyers and sellers, but such elections are available only if the buyer is purchasing 80% or more of the stock of an S corporation. An LLC, on the other hand, can provide a buyer with a step up in asset basis upon an equity purchase, regardless of the amount of the LLC that is being purchased.
An election to tax an LLC as an S corporation can potentially save on taxes. Any such tax savings should be modeled out using realistic assumptions, and a tax advisor should be consulted about whether the same benefit can be achieved without electing S corporation status. Furthermore, that benefit should be weighed against the disadvantages of S corporation status and how those disadvantages may impact the current and future plans for the business.
 There are even more specialized regimes, like those for insurance companies, that are not discussed in this article.
 References to LLCs will mean “LLCs taxed as partnerships” unless otherwise stated.
 Subject to significant exceptions, but this is the general rule.