If I Have an LLC, Am I Automatically an S Corporation?
One of the most common questions business owners ask is whether forming a limited liability company automatically makes the business an S corporation.
The short answer is no.
An LLC and an S corporation are not the same thing. An LLC is generally a business structure created under state law, while an S corporation is a federal tax classification that an eligible business must elect.
What Is an LLC?
A limited liability company, commonly called an LLC, is a legal business structure established under state law. The owners of an LLC are called members.
Creating an LLC may provide legal separation between the business and its owners, depending on state law and how the business is operated. However, registering an LLC with the state does not automatically determine that it will be taxed as an S corporation.
According to the IRS explanation of LLC classifications, an LLC’s default federal tax treatment generally depends on the number of owners:
A single-member LLC is ordinarily treated as part of its owner’s tax return for federal income-tax purposes.
A multi-member LLC is ordinarily taxed as a partnership.
An eligible LLC may elect to be taxed as a corporation.
An eligible LLC may also elect S-corporation tax treatment.
An LLC can therefore retain its LLC status under state law while choosing a different classification for federal tax purposes.
What Is an S Corporation?
An S corporation is a federal tax election. It is not automatically created simply by registering an LLC, obtaining an Employer Identification Number or opening a business bank account.
To receive S-corporation treatment, an eligible business generally submits Form 2553, Election by a Small Business Corporation. The election must satisfy IRS requirements and be signed by the required shareholders.
With an S corporation, business income, losses, deductions and credits generally pass through to the shareholders, who report the applicable amounts on their personal tax returns. The business must also file a separate Form 1120-S and issue Schedule K-1 forms to its shareholders. The IRS S-corporation guidance explains the qualification and filing requirements.
How Are They Different?
The easiest way to understand the distinction is:
LLC: A legal business structure created under state law.
S corporation: A federal tax classification selected by an eligible business.
Forming an LLC: Does not automatically create an S-corporation election.
Electing S-corporation treatment: Does not necessarily replace the LLC under state law.
An LLC can potentially be taxed as a disregarded entity, partnership, C corporation or S corporation, depending on its ownership, eligibility and elections.
Why Would an LLC Consider an S-Corporation Election?
A qualifying business may consider an S-corporation election because it can change how the owner’s compensation and remaining business profit are treated for federal employment-tax purposes.
With a typical single-member LLC using its default tax treatment, the owner generally reports business activity on Schedule C, and net earnings may be subject to self-employment tax.
An owner who works for an S corporation is generally treated as an employee and must receive reasonable compensation through payroll before receiving non-wage distributions. Wages are subject to applicable payroll taxes. Additional business profit may pass through to the shareholder and may not be subject to self-employment tax in the same manner as Schedule C earnings.
This structure may produce tax savings in some circumstances, but the result depends on the business’s profit, reasonable compensation, payroll expenses, state taxes and administrative costs.
What Does “Reasonable Compensation” Mean?
An S-corporation owner cannot simply avoid payroll by taking all the business profit as distributions. A shareholder who performs services for the business generally must receive reasonable compensation before non-wage distributions are made.
Reasonable compensation depends on factors such as:
The owner’s duties and responsibilities
Time devoted to the business
Training and experience
Comparable pay for similar work
The type and size of the business
The business’s financial performance
There is no single salary amount that applies to every S corporation.
An S Corporation Requires Additional Administration
S-corporation treatment can create responsibilities that a default single-member LLC may not have. These can include:
Operating payroll
Making payroll-tax deposits
Filing quarterly and annual payroll returns
Issuing the owner a Form W-2
Filing a separate Form 1120-S
Providing Schedule K-1 to each shareholder
Maintaining accurate bookkeeping and basis records
Meeting state filing and tax requirements
Filing the S-corporation election correctly and on time
These additional expenses and responsibilities are important when deciding whether an election makes financial sense.
Is an S Corporation Right for Every LLC?
No. An S-corporation election may benefit some profitable businesses, but it is not automatically the best choice for every owner.
A business with limited or inconsistent profit may find that payroll, professional preparation and administrative costs outweigh potential tax savings. Ownership restrictions, benefit treatment, state taxes and long-term plans should also be considered.
The decision should be based on actual financial information—not simply because someone online said every LLC should elect S-corporation status.
Let KR Tax Returns 4 Less Help You Understand the Difference
KR Tax Returns 4 Less provides dependable, affordable tax preparation and year-round tax support for individuals, families, self-employed professionals, rental property owners and small businesses. We assist with federal and state tax returns, prior-year and amended returns, business returns, bookkeeping, tax planning, IRS notices and tax-resolution needs.
We can review your business activity, explain how your current entity is taxed and help you understand the tax-filing responsibilities associated with an S-corporation election.
Serving clients in El Mirage, Surprise, Peoria, Phoenix, throughout Arizona and in all 50 states, with convenient virtual appointments available.
Contact KR Tax Returns 4 Less before changing your business’s tax classification so you can make an informed decision.
This article provides general information and is not individualized tax, accounting or legal advice. Forming an entity and electing a tax classification can have legal and tax consequences. Consult appropriate professionals about your specific circumstances.