The Tax Advantages Of Llcs For Startups
From taxes to how much of your personal assets are at risk, you’ll want to pick a business structure that gives you the right balance of legal protections and benefits. Thats where a Limited Liability Corporation comes in.
Unlike a sole proprietorship or partnership, an LLC gives business owners personal liability protections for any actions of the business. Generally, LLCs provide certain tax benefits and greater flexibility, and they also come with a lot less paperwork than C corporations and S corporations.
When it comes to taxes and saving your business money, is an LLC the right structure for startup owners like you? Let’s dig in to weigh the pros and cons.
Can An Llc Purchase A Membership Interest In An S Corp
Generally, no, but there are loopholes in business and finance. The ownership stake of an LLC member is called a membership interest, and owners of an S corp are called shareholders.
An LLC with more than one member cant purchase or own S corp stock because it violates Subchapter S guidelines. However, a single-member LLC taxed as a disregarded entity could own S corp stock, which is uncommon.
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How Do Llcs Get Taxed
When you file as an LLC, the default tax method doesnt require you to pay any taxes at the entity level. Instead, all your companys net earnings flow through to your personal return, where youll incur some income and self-employment taxes on the amount.
There are some slight variations depending on the number of owners your LLC has. Heres how it works in each scenario.
Talk To Your Cpa And Business Attorney
You can make the S-Corporation election by filing Form 2553 either:
- No more than two months and 15 days after the beginning of the tax year the election is to take effect or
- After two months and 15 days into the tax year preceding the tax year when the S-corporation will take effect. For a company whose fiscal year ends on December 31, this means if they file the S-corporation election between March 16 and December 31 of a given year, the election will take effect on the following January 1.
If you miss the deadline to file an S-corporation election, the IRS may forgive you for being late and let you file still. Talk to your accountant about how to get this done .
You also need to obtain the appropriate internal approvals from your Board of Directors and/or stockholders or members or managers and/or board of managers .
Before you elect to be taxed as an S-corporation, speak to your business lawyer and a CPA. This is easy territory to make a mistake and the stakes are significant. This is especially important if you currently have a C-corp because there are many traps for the unwary, including freezing net operating loss and credit carryforwards, which cant be used by the s-corp.
Changing From An Llc To S Corp
Many people think that when they choose S Corp taxation their LLC goes away. But actually, your LLC remains intact. The only change is how your LLC is taxed.
Heres what you need to do to change your LLCs tax treatment. Once your LLC is set up, you need to let the IRS know you want to be taxed as an S Corp. This is done through filing Form 2553.
When should you file your S Corp tax election? For new LLCs, you have 75 days after the date of formation to submit Form 2553. If your LLC has been around for more than 75 days, then you have until March 15 of the current year to file Form 2553. If approved, your S Corp tax election will be retroactive to the first day of the year.
If filling out IRS forms isnt your thing, you can find professional help with the entire process, from forming your LLC to setting up the IRS designation. For some business owners, this is the best choice to make sure they get everything filled out correctly with the state they are doing business in and with the federal government.
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What Certificates Are Required For An Llc And An S Corp
To understand LLCs and S corps, it helps to learn about C corporations. Taxed under Subchapter C, C corps are separate taxable entities that file Form 1120. You can convert an LLC or a C corp into an S corp by filing Form 2553 with the IRS, as long as the business meets all Subchapter S guidelines.
LLCs require business owners to file with the state where the LLC was formed, and these requirements may vary by state, according to Brian Cairns, CEO of ProStrategix Consulting.
Most states require some public notification, which can be costly depending on the jurisdiction, Cairns said. For example, in New York state, you have to advertise in the county in which the LLC is formed. If you form in one of the five boroughs of NYC, this can cost upward of $1,000.
For S corps, youll need to file articles of incorporation in the state where you want to incorporate. An annual shareholder meeting and additional state reporting are also required.
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If You Remember Nothing Else About This S
If you are still confused or dont trust yourself to remember all the details I gave you in this article, remember these few things:
- An S corporation is not a type of entity. It is a tax election that you obtain by filing a piece of paper with the IRS.
- You can elect to tax either an LLC or a corporation as an S-corporation.
- S-corps have lots of rules, so talk to your attorney or accountant before making a Subchapter S election. You will use only a tiny portion of your future tax savings to get solid advice to keep you out of any trouble.
- If you are launching a business/startup that expects to raise venture capital , you probably shouldnt elect for S corp taxation.
Can An Llc Elect For S
Different types of business entities are taxed under different structures, but the unique advantage of an LLC is its flexibility in tax structures. Businesses operating as LLCs can elect to follow the standard LLC tax structure, or the LLC can elect to use S corp tax options.
What Are the Benefits of S Corp Election for LLC?
The primary benefit of choosing election for S corp taxation under an LLC is the flexibility and limited liability of tax options. S corps are treated differently under U.S. tax law, meaning that only particular wages or other income are eligible for taxation vs. the income tax requirements for LLCs. This allows for improved tax planning, while reducing overall taxable income amounts.
Why Not Just Apply for an S Corporation?
S corporations most certainly have their benefits, and S corporation application can be a favorable option for many businesses. However, when it comes to operating an LLC that uses S corp taxation structures, you have the options to take advantage of both S corp and LLC benefits. In particular, LLCs are simpler to form with fewer filings. LLCs also limit owner liability and overall operate under fewer restrictions. Filing as an LLC but electing taxation as an S corp allows you to hybridize your benefits and find the optimal business structure that works to minimize losses.
How to Elect S Corp Status for an LLC
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Can You Change The Classification Back To A Disregarded Entity
Changing your tax classification from a corporation back to a disregarded entity is possible. But there are some caveats from the IRS that you should consider.
Before you wish to switch your tax classification either from LLC to a corporation or vice versa, keep in mind that you can change your tax classification only once in the period of five years. The exceptions are:
- You selected the tax election status when you filled the entity form
- More than fifty percent of business owners have changed.
If you get eligible to switch your classification use Form 8832 to request a change.
Similar rules will be applied if you are switching from an S corporation to a sole proprietor. But for S corporation, you will use Form 2553.
How An Llc Taxed As An S Corp Works
Like a partnership, an S corporation is a pass-through entityincome and losses pass through the corporation to its owners’ personal tax returns. S corporations also report their income and deductions much like partnerships.
An S corporation files an information return reporting the corporation’s income, deductions, profits, losses, and tax credits for the year. S Corp owners must provide shareholders a Schedule K-1 listing their shares of the items on the corporation’s Form 1120S. The shareholders file Schedule E with their personal tax returns showing their share of corporate income or losses.
How Is An Llc Taxed As S Corp
An LLC taxed as S Corp is a business structure that can be used to reduce self-employment taxes because the owner only pays social security and Medicare taxes on salary instead of having to pay those plus a share of profits. In an LLC, income and losses are passed through the business to each owners individual tax return, rather than being taxed at the business level. Since S Corp profits are taxed only once, at the owners individual tax rates and not that of the corporation , setting up an LLC taxed as an S Corp can be a smart move.
By default, all owners of an LLC will be subject to self-employment taxes including social security and Medicare taxes. However, if an LLC is taxed as an S Corp then it can avoid that second level of taxation and pass through its income or losses to the owners individual tax returns just like a partnership or sole proprietorship. The business will still be subject to federal and state corporate taxes, but profits will only be taxed at the owners individual tax rates, which are typically lower than the corporate tax rate.
The Irs Can Reclassify Distributions
On another note regarding S-Corporation reasonable compensation, its important to remember that if at some point, the IRS determines that your salary is not reasonable, they can reclassify the distributions you already took, tax them, and add on penalties, interest, and fines.
These federal cases show the IRS ability to reclassify distributions:
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How Does Taxation As An S Corporation Differ From Taxation As A Sole Proprietorship Or Partnership
Sole proprietorships, partnerships and S corporations are all pass-through entities for tax purposes. But they are not taxed the same. A main difference is that Subchapter S of the Code imposes a number of restrictions on the entities that can select S corporation taxation. In general, the company must be formed in the United States, there cannot be more than 100 owners, only individual, US residents can own interests, and there can only be one class of ownersno preferred shareholders or members. Subchapter K, which governs entities taxed as partnerships, contains no such restrictions. These restrictions take away some of the flexibility of an LLC and can make it harder to attract outside financing.
Another possible advantage comes from the Tax Cuts and Jobs Act. That tax reform bill gives pass-through entities a 20% qualified business income deduction.
However, businesses with taxable income above a certain amount dont qualify unless they pay employee wages. Therefore, under some circumstances S corporation taxation can help an LLC qualify for the deduction. Of course, this a simplified description of a complex matter and the advice of tax experts should be sought out.
What It Means When Your Llc Is Taxed As A Corporation
Many LLCs choose to be taxed as corporations to save on taxes. In this tax situation, the LLC members become shareholders and they are not self-employed.
For higher-income individuals or those with profitable LLCs, the fact that corporate shareholders don’t have to pay tax on their share of income from the corporation is a tax advantage. The corporate rate may be lower than the owners’ personal tax rates.
You also avoid having to pay self-employment tax, unless you work in the corporation as an employee .
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The Best Of Both Worlds: Having Your Llc Be Taxed As An S Corp
If youre still feeling indecisive, this might help: You can elect to have your LLC taxed as an S corporation. This was the approach I personally used in my business I wanted the simplicity of an LLC, but the tax savings that come with an S corp classification.
Roberts agrees. Setting up as an LLC then electing to be taxed as an S corp can sometimes be the best of both worlds. It combines the ease of owning a flexible creature of contract an LLC with the tax savings of a corporation. When done right, the savings can be huge, particularly when it comes to self-employment tax.
Wheeler notes that this election depends on your numbers and your profitability.
Ultimately, it comes down to whether you have sufficient profits to pay yourself reasonable compensation plus some, she says. Otherwise, you wont get to take advantage of the S Corp tax benefits. Whats reasonable compensation depends on your industry, the work you do, how experienced you are, etc. and you also need to consider the state youre located in. California, for example, taxes S Corps at a higher rate than LLCs. Bottom line make sure youre working with a tax advisor who understands S corps and start the conversation early.
If you choose this option, be prepared for some extra paperwork.
Dont forget to consider the additional administrative burden the S Corp election means taking extra steps and the tax savings may not be worth the extra burden in every case.
Can A Single Member Llc Be Taxed As An S Corp
A single-member LLC is automatically taxed as a disregarded entity: the income from the LLC is reported on the personal income tax return. However, even single-member LLCs can choose to be taxed as an S corp. They still need to meet eligibility requirements, such as having a consent form signed by all LLC members, filing for this change on a predetermined date, and designating a tax year with a clearly stated date that will serve as the beginning of the tax year.
If these requirements are met, an LLC can file for an S corp status and get the most important S corp advantage no double taxation. In cases where a single-member company becomes an S corp for taxation purposes, the owner can make themselves an employee, pay their reasonable salary, and retain any other profits as distribution. The owner doesnt have to pay self-employment taxes on income they earn from the LLC.
|DID YOU KNOW? Every LLC has to list a registered agent in the companys formation documents. If youre having trouble locating one for your LLC, you can find one here.|
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Llc And S Corporations: Key Differences
Between the two forms of corporation, it is easier to run an LLC. The LLC has fewer requirements for paperwork for the state, fewer meetings are required, and it also has lower start-up costs. This provides an advantage for smaller businesses because:
- It eliminates the extra paperwork that a C or S Corporation requires.
- It enables owners to disperse profits and losses in more ways. Owners can divide profits with greater flexibility, letting each owner be taxed accordingly.
- Owners are taxed according to their ownership percentage.
- Owners can disperse part of the profit through wages or salaries, and the rest through distributions. Only the wages or salaries earned are available to be taxed under Social Security and Medicare in an S Corporation.
Tax Differences: What Are The Taxes Involved For All Entities
1. Pass-through Taxation
The first thing you need to understand about entity taxation is pass-through taxation.
Sole proprietors, partnerships, LLCs, and S-Corporations are taxed as pass-through entities.
This means that all income your business receives passes through to you personally.
For example, if your business made $100,000 and you owned 100% of that business, then you would be required to pay taxes on that $100,000 individually.
The exact tax you pay on that will depend on the tax bracket your total personal income falls in.
2. Double Taxation
Only C-Corporations are subject to double taxation.
Double taxation is where the company itself is taxed on all of its profits, before payments to owners are made.
And then the owners are taxed on payments they receive from the corporation.
So, youre taxed twice.
Because of double taxation, C-Corporations are not a popular choice amongst small businesses.
But lets discuss a major tax that most small businesses encounter as pass-through entities.
3. Self-Employment Tax
Self-employment tax is an extra 15.3% tax on your income.
Its the governments way of funding programs like Social Security and Medicare, which is normally deducted from your paycheck as an employee.
The only difference is, as a business owner, youre paying both the employer and employee portion of the tax, equaling a total tax of 15.3%.
Now heres the thing about self-employment tax, it does not apply to S-Corporations or C-Corporations.
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