When you’re ready to set up your new company, you will learn about several factors to consider such as liability protection, simplicity of the process, number or shareholders, and tax treatment among others.
As far as the simplicity of the process and ongoing requirements, in comparison with a C Corporation or an S Corporation, the Limited Liability Company (LLC) requires fewer forms for registering and you’re not required to have formal meetings, file annual reports or keep minutes.
When it comes to tax treatment for your company, it is important to remember that one of the advantages of forming an LLC is that it allows maximum flexibility for choosing a method of federal taxation. For example, if you form a corporation must be taxed as either a C Corporation or S Corporation. However, if you decide to form an LLC, you have a wide variety of tax treatment elections to choose from. Specifically, you elect to be taxed as a partnership, taxed as a C Corporation, taxed as an S Corporation, or a sole proprietorship (if your LLC is a single member LLC).
This article outlines the tax implications of electing the S Corporation tax treatment so you can determine if it is the best for your business. And of course, you should always seek advice from a tax professional to discuss your particular situation. And also, for further clarification, the content of this article is not intended to be legal or tax advice, but rather is a general description of the types of taxation you may elect when operating an LLC and some of the general characteristics of each structure.
But before we get started, it is important to clarify the default tax classifications of an LLC. When your LLC is initially formed, the IRS creates a default method of taxation for the LLC based on the number of members the LLC has. The default classification for a single member LLC, whose sole member is an individual, will be a sole proprietorship. A multi-member LLC will have a default classification as a partnership.
Only you and your partners will be able to decide if choosing the S Corporation tax classification for your LLC is best for you.
In order to be eligible for S Corporation taxation, the members of the LLC must meet certain eligibility requirements. To elect S corporation tax treatment, you need to file Form 2553 with the IRS. This filing is time-sensitive. For brand new companies, you need to file it before the first 75 days for it to take effect for the current tax year. If you’re an existing company, you will need to file the paperwork within the first two months and 15 days since the beginning of your tax year. For example, if you have an existing company and you want elect the S corporation tax treatment for tax year 2016 (assuming you report on the calendar year), then you will need to file Form 2553 in by March 15, 2016. To qualify for the S Corporation classification, your business can only have one class of stock, have no more than 100 shareholders, and all shareholders must be U.S. residents.
When you request S corporation status for your LLC, the company remains an LLC from a legal standpoint, but is treated as an S corporation for tax purposes. S Corporations are a pass through entity taxed under subchapter S of the Internal Revenue Code. A pass through entity does not pay tax; rather, the S Corporation passes earnings and losses through to the shareholders, thus avoiding the double-taxation associated with C Corporations. Instead, the shareholders of the S Corporation report the earnings or losses of the S Corporation on their personal income tax return. In other words, the S corporation status gives you the option to divide up the company’s earnings into salaries and then passive income in the form of distributions. Salaries are subject to FICA tax (social security and Medicare), but the distributions are not. Under the sole proprietorship method of federal income taxation, all of the net profits are subject to the self-employment tax.
In conclusion, only you and your partners will be able to decide if choosing the S Corporation tax classification for your LLC is best for you. And again, you should also check with your tax advisor if you need help determining if this configuration is right for your particular situation.
Until next time, this is Manuel Gil del Real (MGR)