For entrepreneurs who want to set up a company and avoid double taxation (i.e., taxation of amounts earned by the company and then taxation of the owners when they receive payments from the company), the choice often comes down to using an S-corporation or LLC (limited liability company). What if the entity could be both?
LLCs are generally and by default considered partnerships for income tax purposes, so there is no entity level tax. Profits and losses are passed through to the owners. S-corporations are corporations that the owners have elected for the profits and losses to be passed through to the owners like a partnership, but otherwise, the entity is still treated as a corporation.
Interestingly, however, you can set up your entity as an LLC and then file an S-election so that the IRS treats your LLC as an S-corporation. In essence, you have an LLC that elects to be taxed like a corporation that has made an S-election.
Why would anyone do this if you already have pass-through taxation in the LLC? There is at least one potential advantage to being an S-corporation over an LLC for income tax purposes. Specifically, since the IRS views corporations and their owners separately, there is some flexibility in how the owners – employees of an S-corporation may be paid (and thus, taxed).
In an LLC, all earnings are passed through to the owners in the form of self-employment income, which is subject self-employment tax for social security and Medicare. In an S-corporation, however, earnings may be divided between salary and distributions to the owners who are also employees. Only the salary is subject to FICA tax for social security and Medicare. Any distributions made to the owners of an S-corporation are not. Note that any salary paid to owner of an S-corporation must be at a market rate and the same as someone with the same position, but is not an S-corporation owner. Otherwise, the IRS can treat profit distributions as salary.
There are several other limitations for S-corporation that mitigate this advantage. For instance, the number of owners of an S-corporation is capped, only U.S. individuals and certain trusts and estates may own interests in S-corporations (not entities like partnerships, corporations or LLCs), and there can only be one class of equity for all owners of the S-corporation.
The one class of equity limitation severely reduces one of the key advantages of an LLC, which is that profits and losses can be allocated by agreement and not by percentage ownership. In an S-corporation all profits and losses must be allocated, and all distributions made, based on the owners’ percentage of ownership. Given this limitation, if an LLC does elect to be treated as an S-corporation, special attention should be given to LLC’s operating agreement. Many common provisions must be altered or removed entirely, so as not to run afoul of the S-corporation rules.
So while an LLC may elect to be treated like an S-corporation, it might not be the best of both worlds for everyone. Make sure you consult a tax attorney before making an S-corporation election!