With the holidays in full swing, the approaching tax season might be the furthest thing from your mind. But if your business did well this year, you need to give this issue some attention now. How much you pay in taxes could depend on your business structure. If you formed your business as a Limited Liability Company (LLC) so you would face less stringent compliance issues and be able to protect your personal assets from liability, you still need to decide how you want the business to be taxed. As an LLC, your business can be taxed as a sole proprietorship, a partnership, a C Corp or S Corp, if the business meets certain qualifications. If you decide to go the S Corp route, the deadline to elect S Corp status is March 15, so here’s what you need to know now.
Paying Taxes as an LLC
Most small business owners who don’t start their business as a sole proprietor, choose the LLC structure because of its relatively less complex and less costly formation requirements. The LLC business registration paperwork is minimal and there are less ongoing filing requirements than with a corporation. The biggest advantage comes from the fact the LLC is considered a separate legal entity from its members, similar to a corporation. Because the financial and legal responsibilities belong to the LLC, owners/members are not held responsible in the case of a lawsuit or debt settlement.
When it comes to taxes, by default taxes are applied in the same way as if the business were a sole proprietorship or partnership. In other words, business income and losses are passed through to the members’ tax returns and subject to members’ individual tax rates. The LLC can also choose to be taxed as a corporation, with profits taxed at the corporate rate (which is now a flat 21% due to the Tax Cuts and Job Act). The other option is to choose to be taxed as an S Corp, which allows for the LLC to have pass-through taxation, while also enjoying a reduced self-employment tax.
Here’s what to know about electing S Corp status.
Paying Taxes as an S Corp
First, the S Corp is not a legal business entity type in and of itself, like the LLC and C Corp are. The S Corp is a special election which allows owners/members to pass business income, losses, deductions, and credits through to their member shareholders for federal tax purposes. Shareholders of S Corps are then required to report the income and losses on their personal tax returns.
Not all LLCs are eligible to elect S Corp status, however.
To qualify for S Corp status, the company must:
- Be based in the United States
- Have only shareholders who are residents of the U.S.
- Have no more than 100 shareholders
- Have only one class of stock
The reason members of an LLC might choose to elect S Corp status is because of the treatment of employment taxes. If the business owner is taxed as a sole proprietorship or partnership, the owner is still required to pay the appropriate employment taxes as the employer. An LLC member taxed as an S Corp is considered an employee and therefore only the income designated as wages is subject to self-employment taxes (FICA tax for Social Security and Medicare). Other earnings that pass-through to the members are considered dividend monies and not subject to self-employment taxes.
March 15th is the deadline to file IRS Form 2553 with the IRS and elect S Corp status. If you miss the deadline, the LLC business will remain as is and the S Corp election will be effective the following tax year. Don’t think once you’ve elected S Corp status your responsibilities are done. To keep S Corp status, you must meet ongoing filing requirements such as:
- Report financial activity (Form 1120S, Schedule K-1s for shareholders)
- Withhold federal income tax, Social Security and Medicare taxes from employees’ wages
- File IRS Form 941 each quarter to report these withholdings.
- File a Federal Unemployment Tax Return annually (IRS Form 940)
Missing deadlines may mean penalty fees for your business. You can also lose S Corp status by violating any of the qualifications such as having too many shareholders or by earning more than 25% of the business’s gross income from passive investment income. You can voluntarily terminate S Corp status, but you must have at least 50% of shareholders agree and then submit a statement to the IRS detailing the number of shares, which shareholders voted to terminate S Corp status and have all members sign the form.