The LLC is a popular entity choice for small businesses in Washington, and it’s easy to see why. LLCs offer the limited liability of a corporation but without many of the burdensome corporate formalities required to maintain a liability shield. They also provide plenty of flexibility for structuring the economic and control arrangements for the company.
But that’s not all. LLCs also offer flexibility in how they’re taxed. One notable example, and the subject of this post, is when LLCs elect to be taxed as S corporations.
Related: How To Form A Washington LLC
Clearing Up Confusion
If you’re confused at this point, you’re not alone. It’s not at all intuitive that an LLC, which is not a corporation, can be taxed as a corporation without, in fact, becoming a corporation.
The key to understanding this is to understand that the Internal Revenue Code (i.e., the federal tax code) doesn’t have a specific tax regime for LLCs—which, as a reminder, are creatures of state law. Instead, the federal tax code treats LLCs as if they were other types of entities: for instance, partnerships or corporations. Unless LLCs elect otherwise, they will be taxed according to certain default statuses by the IRS.
For single-member LLCs, their default tax status is as a sole proprietorship. For multi-member LLCs, their default tax status is as a partnership.
Related: Starting Your Business: Tax Considerations
Benefit Of S Corporation Tax Treatment
Having said that, an LLC can instead elect to be taxed as an S corporation. The primary benefit of doing this as an LLC member is that you don’t have to pay self-employment taxes on some of the LLC’s profits, which can lead to significant tax savings.
There is a catch, though. You must be paid a “reasonable” salary, which is subject to Social Security and Medicare taxes (which are what self-employment taxes consist of). Thus, to reap the tax savings from the S corporation election, an LLC must have profits that exceed the reasonable compensation paid out to the owner or owners.
Let’s look at two examples to illustrate this concept.
Example 1: You have a single-member Washington LLC taxed as an S corporation. You pay yourself a salary of $60,000, which your accountant advised you is a reasonable salary for your position in your industry. Your profits for the year are $80,000. While you do pay Social Security and Medicare taxes on your $60,000 salary, you don’t have to pay self-employment tax on the $20,000 in profits left after you’ve paid yourself a reasonable salary. The self-employment tax rate is 15.3% meaning you’re looking at meaningful savings because of your S corporation election.
Example 2: Same scenario as Example 1. But this time your profits for the year are only $60,000. So after you pay yourself reasonable compensation of $60,000, there are no remaining profits. Consequently, the S corporation election has not saved you any money on self-employment taxes.
What’s A “Reasonable” Salary?
Wait a minute, you might be thinking, why not just pay yourself a measly salary (e.g., $1) and maximize the remaining profit to save on self-employment taxes? The answer is that the salary you pay yourself must be “reasonable” in the eyes of the IRS. Any gamesmanship here could wipe out your saving on self-employment taxes if the IRS comes knocking.
But what exactly is “reasonable”? Unfortunately this a fact-specific question. There are guidelines to consider—for instance, the market salary range in the industry and region for a comparable job—but when in doubt, it’s a good idea to consult with an accountant. But at the very least, you’ll want to make sure you can pass the laugh test when setting your salary.
Downsides To S Corporation Treatment
While the self-employment tax savings can be a huge boon to LLCs that opt to be taxed as S corporations, there can be drawbacks as well.
For example, if you elect for your LLC to be taxed as an S corporation, you’ll have to become an employee of the LLC, which will mean registering the LLC as an employer in Washington (assuming you don’t already have other employees). This may require you to start paying taxes to fund unemployment insurance in Washington, which could eat into the potential savings on self-employment taxes.
Hiring an employee also means the business will also now have to implement and operate a payroll system, which is easier in this era of abundant software solutions, but is nonetheless an additional thing to do and pay for. In short, expect your administrative time to increase as a result of making the S corporation election and hiring your first employee.
In addition, the complexity and, therefore, the cost of tax preparation for an LLC taxed as an S corporation increases, particularly for single-member LLCs previously taxed as sole proprietorships. This will continue to eat into your savings on self-employment taxes, so make sure to run the numbers before you rush into an S corporation election.
There are other potential financial downsides to electing S corporation tax treatment, so make sure to speak with an accountant before deciding to make this election.
Restrictions On S Corporation Election
Finally, you should be aware that there are a handful of eligibility restrictions for making an S corporation election, leaving some businesses ineligible to make this election. In order for an LLC to be eligible to be taxed as an S corporation, it must meet all of the following requirements:
- It must be a domestic entity
- It must have 100 members or less
- The members must be individuals, estate, or tax-exempt organizations (i.e., they cannot be partnerships or corporations)
- It can have no nonresident foreign members
- It can only have one class of membership interest
- It cannot be a bank or an insurance company
- All members have to consent to be taxed as an S corporation
Failing to meet these requirements will cause the LLC to revert back to its default tax status, meaning that single-member LLCs would revert to sole proprietorship tax treatment and multi-member LLCs would revert to partnership tax treatment.
Electing S corporation tax treatment can provide signficant benefits to some LLCs, but it’s definitely not the right choice for every LLC, as you can begin to see from reading through some of the potential downsides to making this election. That’s why it’s essential to consult with tax and legal experts before making this decision for your company.