A limited liability company is a legal entity that’s formed under state law. A big part of why many businesses opt for this structure is while it offers many of the advantages of a corporation, it’s both easier to form an LLC and operate it.
When an entity like an LLC is formed, it receives a default form of tax treatment. For LLCs owned by more than one person, that default is taxation as a partnership. If an LLC only has one owner, its default form of tax treatment is as a sole proprietorship.
While many businesses opt to keep their form of default tax treatment, it’s worth knowing that other options are available. Specifically, an LLC can choose to switch their tax treatment to a C or S corporation. Making this switch is much easier than many business owners expect.
Understanding S Corporation Taxation
In the eyes of the IRS, an LLC that has elected to be taxed as a C or S Corporation is that entity. So when it comes to deciding whether or not your business should elect for this type of taxation, it’s important to understand the full scope of implications.
Partnerships are considered pass-through entities. What that means is both income and losses are passed through the partnership to the personal tax returns of the owners. S Corporations are also pass-through entities. The forms filed by S Corporations include an information return via Form 1120S and then shareholders file a Schedule E with their Form 1040.
One of the key factors that separates partnership tax treatment from an S Corporation is the owners’ employment status. With a standard LLC partnership, owners are not viewed as employees and taxed accordingly. But with an S Corporation, owners who perform more than minor services for the corporation will be both employees and owners for tax purposes.
With this type of treatment, an owner needs to be compensated with a reasonable salary. Then the owner reports this salary and pays the relevant share of Social Security and Medicare taxes. The S Corporation is also responsible for withholding all applicable taxes.
Although that may sound more complicated and potentially less advantageous, the potential benefit of being treated as an S Corporation comes from not having to pay employment tax on distributions. For businesses with significant distributions, this provides a way to save a meaningful amount on both Social Security and Medicare taxes.
Donohoo Accounting Services has 20 years experience in helping clients resolve their tax and financial issues. If you have additional questions about which tax treatment is best for your business, you can get the answers you need by working with us. Call our office now for a free consultation at 513-528-3982.