LLC Elects S Corp Status—The Best of Both Worlds?

By Robert Steere, Toolkit Staff Writer

So you are ready to start a small business, eh? You have a wonderful vision for a unique new service or special product. Your business plan is a work of art. You are ready to cast off from the safety and security of your cubicle at the office and blaze a new trail of entrepreneurship. Congratulations!

Now, as you start, run and grow your new business, how do you intend to structure it so that it becomes an efficiently operating, thriving enterprise? Two of the most popular organizational forms today are the limited liability company (LLC) and the S corporation. But what if I told you that you could have the best of both worlds, so to speak, by establishing an LLC and then electing to be treated like an S corporation for tax purposes? Well, it can be done.

Business owners--even attorneys and accountants--often get twisted up in the debate over which is best, the LLC or the S corporation. But it's not necessarily an either/or proposition. Rather, you can set up an LLC and, after setting it up, you can elect to have the LLC treated as an S corporation. If your LLC operates an active trade or business, and payroll taxes (SECA taxes) on the owner or owners are high, you may find that an S corporation election is the best choice.

Both organizational forms share the characteristic of "passing-through" their income to the owner(s). Both also provide their owner(s) limited liability protection. But each has some distinguishing features, too. You, as a new business owner, will want to consider the differences as you choose the form for your enterprise.

• An LLC beats an S corporation for ease of operation and administration.
• An LLC beats an S corporation for profit-sharing flexibility.
• An S corporation beats a typical LLC for flexibility in paying its earnings to owners as either earned income in the form of salaries and wages or passive income in the form of distributions.
• An S corporation beats an LLC for various tax planning purposes.

Before choosing one of these options--or a combination of the two--determine the features that are most important to you and your business.

The Features of an LLC

An LLC is a business structure authorized by state statutes. It is a structure designed to provide the limited liability features of a corporation along with the tax efficiencies and operational flexibility of a sole-proprietorship or a general partnership. As a pass-through entity (unless it chooses tax treatment as a corporation), all of an LLC's profits and losses pass through the LLC to its owner(s), known as member(s). As with a proprietorship or partnership, each individual member reports the profits and losses on his or her federal tax return. This avoids the double taxation to which a regular corporation and its owners are subjected.

However, the LLC still provides a limit on the personal liability of its member(s) in much the same way a corporation does. Typically, a member's personal liability is limited to his or her investment in the LLC. This feature distinguishes the LLC from a sole proprietorship or general partnership, in which each owner is subject to liability for all of the debts of the business.

The features of an LLC may make it an excellent choice of structure for your new business enterprise. The following summarizes the most significant features of the LLC:

• limited liability for owners;
• pass-through of income to owners, avoiding double taxation (unless corporate treatment is elected);
• ease of operation--fewer filings, fewer forms, fewer start-up costs, fewer formal meetings and record keeping requirements;
• fewer profit-sharing restrictions--earnings distributed as members see fit; not based on percentage of capital contributions;
• entire net earnings of LLC passes through to owners in the form of self-employment income subject to 15.3 percent SECA tax (self-employment tax for Social Security and Medicare).

The IRS does not recognize the LLC as a taxpayer classification for federal tax purposes. For tax purposes, an LLC normally reports as a sole proprietorship or a partnership, depending on whether it is a single- or multi-member LLC. However, an LLC can elect to be treated as an association taxable as a corporation by filing Form 8832, Entity Classification Election. As an alternative, an LLC can file a Form 2553, Election by a Small Business Corporation, to elect tax treatment as an S corporation.

The Features of an S Corporation

An S Corporation is a corporation authorized by state statutes that then elects (by submitting Form 2553 to the IRS) to pass corporate income, losses, deductions and credits through to its owners (shareholders) for federal tax purposes. S corporation owners then report the income and losses on their personal tax returns and are assessed tax at their individual income tax rates. Thus, S corporations avoid double taxation on the corporate income.

Certain limitations are placed on a corporation that seeks treatment as an S corporation. But if these limits don't interfere with your business plans, the S corporation may be a good choice for you. Following are the main S corporation limitations:

• It must be a U.S. corporation.
• It must have no more than 100 shareholders.
• Its shareholders can only be individuals, certain trusts, and estates; they may not be partnerships, corporations or non-resident aliens.
• It can have only one class of stock.
• Certain financial institutions, insurance companies, and domestic international sales corporations are ineligible.

A key feature of the S corporation is its ability to minimize overall tax liability for you and your business. Because of its nature as a corporation, only the wages paid to its owner/employees are earned income subject to FICA tax for Social Security and Medicare. Other net earnings that pass-through to the owners are considered passive income not subject to SECA tax. Thus, an S corporation can do some tax planning that can not be accomplished in a typical LLC.

The most important features of the S corporation include the following:

• limited liability for owners;
• pass-through of income to owners, avoiding double taxation;
• the business exists independent and separate from the owner/shareholders;
• complex administrative operation--more forms and filings required, more formal meetings and record keeping requirements imposed (bylaws, meeting minutes, written resolutions, etc.);
• profit-sharing restrictions--earnings distributed proportionate to capital contributions of shareholders;
• flexibility in distributing earnings of the corporation by paying wages and salaries to owner/employees and passing-through other net earnings as passive income to owners.

Combining the Benefits of the LLC and the S Corporation

If you think you can benefit from the combined features of an LLC and an S corporation, the surprising possibility exists to establish your business as an LLC, but then make the election to have it treated as an S corporation by the IRS for tax purposes. You'll have to make the special election with the IRS using Form 2553. It's no more difficult that setting up a corporation and then electing S corporation status. But it may have some added benefits. Let's take a look.

• From a legal standpoint, your enterprise will be an LLC rather than a corporation. Therefore, you will have the benefit of ease of administration--fewer filings, fewer forms, fewer start-up costs, fewer formal meetings and record keeping requirements. I can hear your sigh of relief!
• From a tax perspective, your enterprise will be treated as an S corporation. You'll still have the pass-through of income, avoiding double taxation, same as if your LLC was treated as a proprietorship or partnership.
• Without the administrative hassles of actually being a corporation, you will still benefit from the IRS treating your business as one. To the IRS, your business will exist separate and independent from you--its owner. Therefore, the business entity can pay wages and salaries to you or to other owners. This amount will be subject to FICA tax and other withholding requirements. But then, it can distribute the remaining net earnings to you and the other owners as passive dividend income, not subject to SECA tax.
• Being treated as an S corporation may provide opportunities for tax planning to minimize the overall tax liability for your business and you. It may allow your business to take advantage of better tax treatment for certain fringe benefits, too.

Obviously, you need to carefully consider the pros and cons of different forms of business organization. Be sure to consider how all the aspects--legal, tax and operational--of each organizational form will impact your unique business enterprise. Seeking professional advice from a CPA or tax attorney is always a wise practice when making choices like this that can affect your business for many years to come.

But setting up an LLC and then electing treatment as an S corporation may just give you the best of both worlds--the ease of administration of the LLC and the tax planning opportunities of the S corporation. Talk to your professional advisor today.