Generally, an LLC's owners (i.e., members) are taxed by the IRS instead of the LLC itself. But did you know that LLC members can change how the IRS taxes them?
LLC members can opt for S-Corporation taxation status in an attempt to lower their taxes. This post will explain what the S-Corp election means and how it can impact a small business.
How it Works
Typically, LLC members pay income tax and self-employment tax on any profits the LLC makes. However, if the LLC makes the S-Corp election, the company can provide non-wage distributions of profits and losses to the members that are not subject to the self-employment tax.
To illustrate further, any members who do work on behalf of the company are paid salaries separate from, and in addition to, their non-wage distributions. These salaries are taxed as normal W-2 income (which includes employment taxes paid by the company and the employee). Such employment taxes would only apply to these salaries, not the non-wage distributions, resulting in lower tax liabilities in certain circumstances.
For example: if a single-member LLC makes $100,000 profit in a taxable year and does not take the S-Corp election, the member will pay ordinary income tax and self-employment tax on any profit the LLC makes during a taxable year. However, if the LLC makes the S-Corp election, the member will not pay self-employment taxes on the portion of the $100,000 paid to themselves as non-wage distributions.
One Use Case of the LLC S-Corp Election
Taking the LLC S-Corp election can further reduce taxes owed if there is a multi-member LLC, but not every member does work on behalf of the company (i.e., some members act as passive owners). These members could potentially save a lot on taxes by having the LLC take the S-Corp election.
Legal Considerations of the LLC S-Corp Election
While the S-Corp election sounds great in theory, putting it into practice without falling into the severe audit bin is somewhat tricky.
LLC members must pay themselves a "reasonable compensation" for services they provide to the company. In other words, they cannot just pay themselves non-wage distributions and no salary.
IRS Guidelines on Reasonable Compensation
The IRS does not have a specific rule in determining what constitutes reasonable compensation. Instead, they use a few different guideposts to measure whether the compensation is reasonable.
Importantly, the IRS looks to the company's gross receipts in determining whether the compensation is reasonable. This analysis considers the following:
Services of shareholder;
Services of non-shareholder employees; or
Capital and equipment.
The IRS looks at these factors to examine how much work the member puts into the company in relation to gross receipts. The more gross receipts that come from the member's services, the more the member has to pay themselves in compensation (which requires employment taxes to be paid). Additionally, the IRS looks at the administrative work the member does at the company. Although the member's work might not directly create gross receipts, the work is still tangentially important to the company’s revenue.
Additional factors the IRS considers in determining reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
The use of a formula to determine compensation
Conclusion
In going forward with a S-Corp election, it is important to review all the information carefully and create a well-reasoned salary. Taking the S-Corp Election is serious decision and should not be made without seeking the advice of legal counsel and an accountant. If you have any questions, please do not hesitate to contact me.
The information provided on my blog is not legal advice and should not be relied on as legal advice. Anyone reviewing this post should use it as only a first step in understanding how the S-Corp election works. LLC members should consult with a lawyer before making any decisions.
Helpful Links:
IRS - S Corporation Compensation and Medical Insurance Issues IRS - S Corporation Employees, Shareholders and Corporate officers