Many limited liability companies (LLCs) use the S-Corporation distinction – and for good reason – an LLC with S Corp election is one of the most common new strategies for both liability and tax benefits. The reason people like to use the LLC as an S Election is simply that the owners typically get to take home more money by saving on certain taxes.
This article reviews LLCs and S-Corps, why the combination works well, and how to set up your company to utilize the advantages of each.
First, let’s clear up a common misconception. An S-Corporation is simply a tax filing election with the IRS. It is not an entity type. It can be used as the filing status with either an LLC or a Corporation, among other entities.
The limited liability company is a fantastic way to get liability protection (meaning protection of your assets) without rigid corporate formalities. There are limitations, but for most small and medium-sized companies, the LLC works beautifully.
LLC liability protection let’s owners or shareholders invest in the business without risking their personal assets. For this reason, companies are able to raise capital from investors and owners are able to take risks, which help businesses and the economy thrive.
In addition, the flexibility offered by the LLC helps each company customize how it will operate. LLCs select if they want to be member-managed or manager-managed. They also allow companies to operate as formally or informally as they want – have board meetings or not, for instance. Additionally, they can spell out all the terms and conditions in an operating agreement between the owners.
Companies operating as an LLC can also select how they want to be taxed. They can be taxed as an S Election or partnership.
What is an S-Corporation?
According to the Internal Revenue Service (IRS), “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.”
The IRS continues by explaining, “To qualify for S corporation status, the entity must meet the following requirements:
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).”
Why do LLCs and S-Corps Pair Well?
The LLC allows for various tax strategies. One way LLCs are taxed is by using the S-Corp designation. The S-Corp is described above, but anyone using it should realize the pass through element simplifies taxes. Being taxed at a corporate level is sometimes more burdensome, but there are advantages. Opting for pass through or S-Corp taxation is fairly straightforward because each member simply applies the companies’ tax information to their personal tax returns.
Additionally, the operating agreement used by an LLC clarifies member interest and tax issues. In other words, there is a written agreement for every member to reference.
How to Create an LLC with an S-Corp
Each state is a little different, but for most it’s as simple as following instructions on the secretary of state’s website – the state secretary of state. If you are in North Carolina, go to the North Carolina secretary of state website and set up your LLC. The same is true for any state. For the most part, you can easily complete the processes in the principal place of business for the company. Once the fee is paid and application is complete, you’ll have an LLC.
You will also need an operating agreement and company bank account. The operating agreement can be as simple or as complex as needed for the company. The bank account is easy to set up.
Two Steps to Get LLC with an S Corp Election
First, file an LLC here (or with SOS or using attorney). Be sure to complete your operating agreement as well (this is included in most services).
Next, visit the IRS website which explains the following: “In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders.” You (well, preferably, your accountant) will file Form 2553 with the IRS. Found here: https://www.irs.gov/pub/irs-pdf/f2553.pdf.
LLC and S-Corp – Quick Example
“Goofy Guys” is a comedy act for kids. It’s owned by two lifelong friends. They want to split profits 50/50 and share the work, afterall their routine is daily evenly shared – same with the laughs. Both hate paperwork and filings, however. They use a bookkeeper and web gal so they can focus on making laughs, not paper. The tedium of business ownership is daunting, but they both love entertaining and comedy.
For the “Goofy Guys,” they could pay themselves as employees and then also save taxes on distributions. There are some rules about how much you should pay yourself in salary versus distributions.
You can use Drafted Legal to set up the LLC; however, we recommend you use an accountant to provide advice regarding the S Election to make sure it is worth it for your business and done correctly.