The Limited Liability Corporation (LLC) has evolved into one of the most commonly selected entity types for American businesses. The benefits of the LLC are many, and include strong liability protections for the owners as well as potential tax advantages and ease of operation and administration.

On the other hand, an S corporation enables you to pay wages to the owners as well as make distributions of income previously taxed. In contrast, traditional LLCs do not allow owners to be paid wages, so all earnings come as distributions. And S corporations offer greater benefits for many forms of tax planning.

So, how can you gain the benefits of both an LLC and an S corporation for your business entity? Well, if the business is active in trade (rather functioning only as a passive entity), you should seriously consider filing with the IRS to have your LLC treated as an S corporation.

How is that possible? Remember that the legal structure of an entity created in a given state does not directly correlate with how that same entity is viewed or treated at the federal level by the IRS. In fact, the IRS does not even recognize the LLC as a taxpayer classification. For example, by default the IRS treats single-member LLCs as sole proprietorships.

However, you can tell the IRS how you want your LLC to be treated. Form 8832, the IRS Entity Classification Election, allows you to elect that the IRS should view your LLC as a corporation. Form 2553, Election by a Small Business Corporation, then allows you to elect that your LLC (which it now views as a corporation) should be treated as an S corporation. Please note that in many cases, you may be able to skip Form 8832 and just use Form 2553 to accomplish both steps.

NOTE: IRS regulations, forms and requirements change regularly. Consult with your CPA or attorney before taking specific actions associated with electing or declaring your entity’s status with the IRS.

There are some important considerations to keep in mind when evaluating the option of choosing S election for your LLC.

The biggest is employment tax. Since an LLC with S election can pay its owners wages (that are subject to FICA and Medicare payroll taxes) as well as distributions (that are not), some business owners have attempted to minimize their tax liability by paying themselves artificially low wages and directing the rest of their compensation through distributions. However, the official IRS rule is that the entity must pay “reasonable employee compensation” to everyone, including its owners, for the services they perform.

In one case, a CPA firm that was organized as an S corporation paid its owner $24,000 per year in salary and more than $200,000 in distributions. The IRS audited the taxpayer and ultimately determined that the CPA’s professional services were worth $91,000. As a result, nearly $70,000 of the distributions had to be re-characterized as wages, subject to payroll taxes.

Nonetheless, for many entrepreneurs, the benefits of combining the entity format of the LLC with the tax election of the S corporation may make a compelling case.

For more information on effective tax strategies for your business, consult with the team at Haines & Lagerquist CPAs by calling 301-249-0703 or via email to cpa@hainesandlagerquist.com.

Selected Sources:

Electing S Corporation Status for a Limited Liability Company
http://www.aicpa.org/publications/taxadviser/2013/december/pages/casestudy_dec2013.aspx LLC

Electing S Corp Status – The Best of Both Worlds
http://www.bizfilings.com/toolkit/news/tax-info/llc-plus-scorp-equal-best-of-both.aspx

Death Of The S Corp As A Tax Election?
http://www.forbes.com/sites/steveparrish/2013/10/15/death-of-the-s-corp-as-a-tax-election/

S Corporations and Salaries: An IRS Hot Button Issue
http://www.nolo.com/legal-encyclopedia/s-corporations-salaries-an-irs-hot-button-issue.html