When starting a business, one of the first decisions you’ll face is choosing your legal and tax structure. Many small business owners form a Limited Liability Company (LLC) because of its flexibility and liability protection. But there’s another choice to consider: whether to stick with the default LLC taxation or make an S-Corp election with the IRS.
Here’s what you need to know about both options:
1. Default LLC Taxation
By default, a single-member LLC is treated as a disregarded entity and reports income and expenses on the owner’s personal tax return (usually on Schedule C). Multi-member LLCs are taxed as partnerships and file Form 1065, passing income and expenses through to the members. In both cases, all net earnings are generally subject to self-employment tax.
2. S-Corp Election
An S-Corp is not a separate legal entity but a tax election made by filing Form 2553 with the IRS. With this election, LLC owners (or corporations) can pay themselves a reasonable salary and take remaining profits as distributions. The salary is subject to payroll taxes, but distributions are not—potentially reducing self-employment taxes.
3. Taxes: Key Differences
Default LLC: All profits are generally subject to self-employment tax.
S-Corp Election: Only the salary is subject to payroll taxes; distributions may avoid self-employment taxes if structured correctly.
4. Compliance Requirements
LLCs without an election are simpler to run. Electing S-Corp status requires additional compliance: running payroll, filing separate tax forms, and following IRS rules about reasonable compensation and shareholder eligibility.
5. Which One Fits Your Business?
Stick with default LLC taxation if your business is new, earns modest income, or you prefer minimal compliance.
Consider the S-Corp election if your business generates consistent profits that justify payroll, and you want potential self-employment tax savings.
Final Thought
Both LLCs and the S-Corp election provide liability protection and pass-through taxation. The right choice depends on your income, growth plans, and comfort with compliance. Consulting with a CPA ensures you make the decision that best supports your long-term goals.