Taxation is one of the primary considerations when deciding whether to establish your business as a Limited Liability Company. Many LLCs have the option of electing to pay taxes as an S Corporation — and sometimes there are benefits in choosing that tax filing status. But how do you know if you should choose S Corporation tax status for your LLC?
The following discussion gives an overview of the primary considerations that LLC owners take into account in making an S Corporation election. Your specific circumstances may affect the availability or advisability of S Corporation filing status for your LLC. Before you make a final decision regarding the tax status of your business, you should consult with an experienced business law professional.
By default under federal tax law, a single-member LLC is taxed as a sole proprietorship. An LLC with more than one member is taxed as a partnership by default. In either case, the business owners report all business income on their personal tax returns. They also pay self-employment tax (SECA tax) on all income from the business.
However, the LLC member(s) may elect to pay taxes instead as an S Corporation. An S Corporation is a special type of corporation. The “S” refers to the chapter of the Internal Revenue Code that governs this type of business entity. (A C Corporation is another tax option that is outside the scope of this discussion.)
Election for S Corporation tax status affects LLC owners in two primary areas. One significant effect involves employment taxes. The other relates to the Qualified Business Income (QBI) Deduction.
If an LLC makes the election to file as an S Corporation, owners who work in the business generally must be employees of the business and receive a salary. Additional business income may be distributed as the members as dividend income.
When an LLC is taxed as a sole proprietorship or partnership, LLC members pay self-employment tax on all income received from the business. Under S Corporation taxation, an owner-employee of the LLC pays employment tax (FICA tax) only on the salary received as an employee of the business. If the LLC distributes dividends, the member does not pay employment tax on those distributions. In addition, the business pays half of the employment tax on the salary, which further reduces the employment tax burden on the member.
By dividing the income from the business between a salary and dividend distribution, individual LLC members often pay less employment tax under S Corporation status than if the LLC pays taxes as a sole proprietorship or partnership. This result is a primary reason some LLCs elect S Corporation filing status.
As of 2018, the Tax Cuts and Jobs Act allows an S Corporation owner to take a 20 percent tax deduction from business income in certain circumstances. The deduction is called the Qualified Business Income deduction, QBI deduction, or Section 199A deduction.
While LLC members taxed as a sole proprietorship or partnership also may qualify for the deduction, the calculation is substantially different in those situations. The calculation difference may result in tax benefits affecting the QBI deduction of the business owners if the LLC chooses S Corporation filing status. In addition, there are situations in which filing as an S Corporation may enable an LLC to qualify for the QBI deduction when it otherwise cannot.
Importantly, there are limits on the availability of the QBI deduction. Certain types of businesses, called Specified Service Trades or Businesses (SSTBs), are not eligible. That class includes businesses that involve the performance of services, like law firms, medical professionals, accounting and other financial services, athletics, and performing arts. The deduction also is limited or not available at all for higher income taxpayers.
To obtain tax filing status as an S Corporation, an LLC files a form with the IRS. However, an LLC must meet certain requirements to be eligible for filing. The restrictions on the LLC include:
An LLC that chooses S Corporation tax status likely will have to deal with additional administrative work (and paperwork) and more complex tax laws and filings, for both federal and state taxes. If your LLC meets the qualification criteria and the potential tax benefits and tax-planning opportunities outweigh the additional administrative and legal requirements, you should discuss the option of filing for S Corporation status with your professional business counsel.
For additional information about LLCs in Arizona, please read our articles, Should You Form an LLC For Your Arizona Business? and New Arizona Limited Liability Act Impacts New and Existing LLCs.
At Peterson Law Offices, we provide high-quality business law services at affordable prices. We welcome inquiries from business owners throughout the East Valley, including Queen Creek, San Tan Valley, Gilbert, Mesa, and Chandler. Schedule your free initial consultation by calling 480-878-5998 or using our online contact form.
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