The other day I received this email from a corporate attorney: “I just got docs for these guys. They are an LLC that elected to be treated as an S-Corp. Why in the world would anyone do that?
Ah yes, why would anyone do that?
The story goes like this: A company starts out as a limited liability company (LLC) taxed as a disregarded entity or a partnership. Then the company gets an accountant who is looking for ways to add some value. The accountant phones the client and says, “Hey, did you know you could avoid some employment tax (Medicare/Social Security) if you make an S election?”
The accountant’s assertion is true of course, but it’s more complicated than that.
As a reminder, the limited liability company is the chameleon of business entities. It can be taxed in the following ways:
- As a disregarded entity. This is the default if the LLC is owned by just one owner, or in some instances, by a married couple. The tax treatment is just like it sounds—the tax rules pretend the entity doesn’t exist and you report all earnings on your individual tax return.
- As a partnership. This is the default if the LLC is owned by multiple owners.
- As an S corp. An LLC can elect to be treated as an S corp, as long as it does not have more than 100 shareholders, have any entity shareholders (with certain exceptions), have a nonresident alien as a shareholder, or have more than one class of stock.
- As a C corp. An LLC can elect to be treated as a C corp.
So back to the S corp tax play. For whatever reason, income that is passed through an LLC that is taxed as a disregarded entity or a partnership is subject to self-employment tax, but income that passes through an S corp is not.
The self-employment tax rates for 2019 are as follows:
- Social Security: 12.4% on the first $132,900 of income
- Medicare: 2.9% (no floor or cap)
- Additional Medicare: 0.9% on income above $200,000 (for singles) and $250,000 for married filing jointly
I can see you are already thinking, “Gee, I could save 16.2% by electing S corp status? Sign me up!”
Here’s catch #1: A requirement of using an S corp is that employees take a reasonable salary. Why is that a problem? Unfortunately, your salary will be subject to employment tax.
OK, so what’s a reasonable salary? Who knows. But I once talked to a doctor who was audited and the IRS concluded that all of his S corp distributions should have been salary. Why? Because he was the only person working for the S corp and the only money it made was his billings.
Supposing you can argue that part of your business income is not salary, at a minimum, the mantra to follow here would be: “pigs get fat, hogs get slaughtered.” If you are making in excess of $250,000 from the S corp, I would definitely consider your salary to be at least $132,900. This means you aren’t really saving 12.4% by using an S corp, at most you’re saving 3.8%.
Here’s catch #2: You have to be very careful when making the S election.
Remember that one of the requirements of an S corp is that there is only one class of stock. The problem is, most LLC operating agreements include partnership capital account language and preferences in the liquidation waterfall. Any preference, even a seemingly harmless one like a right to capital contributions back first, can invalidate the S election.
So, before you heed the well-intended advice from your accountant consider whether the benefit is really worth it, and if you decide to elect S corp status make sure you do it right.
* Note: There is another potential tax benefit to being an S corp. The new 20% qualified business income deduction has a phase-out which depends on W-2 income of the company. Guaranteed payments in entities taxed as partnerships do not count for this purpose, but W-2 income at an S corp does. So in certain circumstances, being organized as an S corp can increase your ability to take the 20% deduction.
Mike Baker frequently advises with respect to LLCs and S corporations. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.