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Pros & Cons of Taking an S Corp Election

If you have a limited liability company (LLC), taking an S corp election could provide helpful tax benefits and unlock unique options for how part of your income is treated. Choosing whether to have your LLC taxed as an S corp depends on a variety of factors.

What is an S corp election?

Owners of eligible domestic LLCs can choose how the IRS treats the business for tax purposes.

Option One is to do nothing and have the IRS apply the default tax structure:

  • Single-member LLCs are treated as a sole proprietor
  • Multiple-member LLCs are treated as a partnership

Option Two is to take an S corp election and the IRS will treat the LLC as an S corporation:

  • Note: Taking the election does not change your entity structure, but only the way it is treated for tax purposes.

Benefits of S corp status

The key advantage of choosing to have your LLC taxed as an S corp is the ability to distribute part of the company’s profits as dividends and not earnings. Doing so can help owners save a significant amount of money on self-employment tax.

Here is how it works:

Say you are the sole member of an LLC that earns $150,000 in net income. As a pass-through entity, the full $150,000 would be subject to self-employment tax at a rate of 15.3% in 2023 (12.4% Social Security tax + 2.9% Medicare tax), for a total tax liability of $22,950.

If the same LLC had elected to be taxed as an S corp, you could choose to have $100,000 pass through as earnings and $50,000 distributed as dividends. As profits paid out as dividends are free of self-employment tax, the total tax liability in this case would be $15,300, for a savings of $7,650.

Note: Owners must pass through a reasonable percentage of net income as earnings or risk an IRS audit and potential recharacterization of distributions plus penalty and interest payments. A tax professional can help you determine reasonable compensation for your situation.

  • In addition, certain pass-through businesses with S corp tax status may be eligible for a 20% Qualified Business Income deduction through the Tax Cuts and Jobs Act.

Disadvantages of S corp status

While the decision looks easy on the surface, there are consequences to taking the election that must be considered.

  • Extra administrative costs
  • Added recordkeeping and meeting requirements
  • Earnings/dividends ratio impacts tax-deferred retirement plan contribution limits
  • Limits LLC to 100 owners and a single class of shareholders, who must all be U.S. residents (could prevent your company from attracting investors)
  • Paying lower self-employment tax lowers your Social Security benefits basis

The bottom line

If saving on Social Security and Medicare taxes while avoiding double taxation is a high priority, an S corp is the only business tax status that makes this possible.

The 2024 S corp election deadline is March 15

If you own an LLC and wish to take an S corp election for 2023, time is of the essence. The deadline for filing Form 2553 (Election by a Small Business Corporation) is March 15, 2024. Remember that Form 2553 must be signed by all shareholders.

Is an LLC taxed as an S corp right for your business?

Choosing an LLC, but electing to have it taxed as an S corp is a complex matter and not a decision to be taken lightly. While the benefits often outweigh the costs, you should always schedule a meeting with an experienced tax advisor before moving forward.

Contact us today to have an Iota Financial CPA work through your company’s financials and make an entity structure recommendation based on your unique business goals and situation.

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