How Does a Single Member LLC Taxed as an S Corp Work?

When it comes to taxation, a limited liability company (LLC) is the most flexible type of business entity. It lets you elect to be taxed in several ways, including the tax treatment that’s usually only for S corporations.

If you’re interested in the potential tax savings of making that election, here’s everything you should know before deciding, including the pros and cons involved, the eligibility requirements, and the specific impact on your taxes.

Benefits of an LLC Being Taxed as an S Corp

There’s only one legitimate benefit to treating your LLC as an S corp for tax purposes, but it’s significant. Making the election lets you reduce the portion of your business’s earnings that are subject to self-employment taxes.

In fact, besides earning less money, changing the tax classification of your business is the only way to pay less in self-employment taxes. Many of the deductions that reduce your income tax burden, like traditional retirement contributions, won’t help you here.

By default, filing as an LLC means that 92.35% of the net earnings from your business activities are subject to self-employment taxes, also known as FICA taxes. Your net earnings equal your gross revenues minus your tax-deductible business expenses.

The standard self-employment tax rate is 15.3%, of which 12.4% goes to fund the Social Security program, and 2.9% goes toward funding Medicare. As you can imagine, reducing your earnings subject to a 15.3% tax can generate some significant savings.

For example, say your LLC generated $100,000 in net earnings in 2021. Using the default LLC tax treatment, you’d owe $14,130 in self-employment taxes. (92.35% x $100,000 x 15.3%)

However, choosing to be taxed as an S corp might allow you to pay self-employment taxes on just 75% of those earnings, in which case you’d only owe $10,597 in taxes and save $3,532.

How Do LLCs Get Taxed?

When you file as an LLC, the default tax method doesn’t require you to pay any taxes at the entity level. Instead, all your company’s net earnings flow through to your personal return, where you’ll incur some income and self-employment taxes on the amount.

There are some slight variations depending on the number of owners your LLC has. Here’s how it works in each scenario.

Single-Member LLC Taxes

A single-member LLC has only one owner. By default, these are disregarded entities for tax purposes. As the owner, you pay taxes on the business’s net earnings the same way you would if you were a sole proprietor.

That means you generally don’t have to file a separate tax return for your company. Instead, you report your revenues, expenses, and net earnings on your Internal Revenue Service (IRS) Form 1040, Schedule C.

Like a sole proprietorship, you have to pay the 15.3% FICA tax on 92.35% of your net earnings from self-employment. You’ll also owe federal and state income taxes on your net earnings after a few additional deductions.

Multi-Member LLC Taxes

Multi-member LLCs have at least two owners. They’re also disregarded entities for federal income tax purposes, but the owners pay taxes on the business profits as if it were a partnership rather than a sole proprietorship.

That means the owners have to file an IRS Form 1065 for the business to report its partnership income, even though the LLC pays no taxes at the entity level.

In addition, the partnership must issue a Schedule K-1 for each LLC member, which reports that individual’s portion of the company’s profits or losses. Each owner’s percentage is fixed and should be in the LLC’s operating agreement.

Then, at the personal level, each owner has to pay self-employment taxes on 92.35% of the net earnings on their K-1. Finally, they’ll owe federal and state income taxes on their K-1 net earnings minus allowable deductions.

Pass-Through Entities

If you’ve read through guidance about legal entity structures, you’ve probably come across the phrase “pass-through entity.” In simple terms, that refers to companies that pay no taxes at the entity level. Instead, all income passes through to the owners.

Single-member and multi-member LLCs are both considered pass-through entities by the IRS, as are sole proprietorships, partnerships, and S corporations.

Pass-through entities contrast with C corporations, which must pay taxes at the entity and owner levels, leading to the infamous double-taxation problem. C corps have a flat tax of 21% on all net earnings in 2022.

For example, say you’re the sole shareholder of a C corporation that generates $100,000 in net earnings. You would have to file a separate return for your C corp using IRS Form 1120 and pay $21,000 in corporate taxes.

Subsequently, you could keep the remaining $79,000 in the C corp or distribute some or all of it. Your distributions typically count as dividends subject to long-term capital gain taxes but not self-employment taxes.

How Does an S Corp Get Taxed?

Like LLCs, S corporations are pass-through entities. That means they don’t owe any taxes at the corporate level. Instead, earnings from the business flow through to the shareholders according to the percentages in the operating agreement.

Each shareholder must then pay federal and state income taxes on the amount distributed to them after accounting for individual reductions, like contributions to traditional retirement accounts and the standard or itemized deductions.

However, they don’t have to pay self-employment taxes on the S corporation’s net earnings. Instead, S corps must treat their owners as employees and pay them a reasonable salary. Only those wages are subject to the FICA payroll tax.

In addition, the S corporation and the business owner split the 15.3% tax, with each picking up 7.65% on their returns. As a result, you avoid paying FICA taxes on the rest of the S corp’s net earnings distributed to you.

Naturally, this incentivizes you to pay yourself as low a salary as possible to minimize your self-employment taxes. However, that’ll get you in big trouble with the IRS. Your salary must be “reasonable,” and the IRS won’t hesitate to call you on this.

There’s some inherent subjectivity to this requirement, but an easy rule of thumb is to pay yourself a wage equivalent to the market rate for the services you provide your company.

For example, say you’re a freelance bookkeeper, and your S corp generates $90,000 in net earnings. In your city, a bookkeeper with your experience level typically earns $65,000, so you pay yourself an equivalent salary and take the rest as distributions.

For more guidance on what constitutes reasonable compensation for an S corp shareholder-employee, check out the IRS resource and consult with a Certified Public Accountant (CPA).

Using software to track your company’s cash flow makes calculating your taxes much easier. Fortunately, Lendio offers free accounting software for small businesses. Give it a try today!

How an LLC Being Taxed as an S Corp Works

If you elect to have your LLC taxed as an S corp, you’ll follow the same taxation rules outlined in the section above. You must pay yourself a reasonable salary subject to FICA and income taxes, then pay income taxes on distributions of the remaining profits.

To be taxed as an S corp, you must complete and file IRS Form 2553. To qualify for the tax treatment during a tax year, you generally must do so no later than two months and 15 days after the start of the year.

For example, if you’re using the standard calendar year, you must complete and file Form 2553 by March 15th. Alternatively, if you started your business partway through the year on June 1st, you’d have until August 15th.

If you make the election on time, your LLC will receive S corporation tax status for the entire tax year and all future tax years unless you file additional paperwork to revoke the election.

Note that if you elect to have your LLC taxed as an S corp, your legal business structure is still technically an LLC. Remember that when considering issues like personal liability protection and specific state requirements.

Requirements for an LLC To Be Taxed as an S Corp

For an LLC to be taxed as an S Corp, you must meet some fundamental IRS eligibility requirements in addition to filing the forms as discussed in the previous section. These include the following:

• Be a domestic entity
• Have only allowable owners
  • May be individuals, certain trusts, and estates 
  • May not be partnerships, corporations, or non-resident alien owners
• Have no more than 100 owners
• Have only one class of stock; for LLCs, all owners must receive equal rights for distribution and liquidation
• Not be an ineligible entity (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

For more detail on these requirements, you can look at the IRS instructions for Form 2553.

Disadvantages of an LLC Being Taxed as an S Corp

There are a few potential disadvantages to electing to have your LLC pay taxes as an S corp. Typically, the most significant ones to consider are the following:

• Retirement contributions: Filing as an S corp rather than an LLC may reduce the amount you can contribute to some of your tax-advantaged retirement accounts.
• Higher tax preparation fees: Because filing as an S corp requires an additional income tax return for your company, you’ll usually pay an accountant more to complete your taxes each year.
• Reasonable salary mistakes: The IRS can decide the salary you paid yourself wasn’t high enough and reclassify some of your distributions to wages after you file your return. That will increase your S corp tax liability and may cause you to owe back taxes, penalties, and interest.

Most disadvantages of having your LLC taxed as an S corp come from increased paperwork and complexity. There are more moving parts to consider, which may cost you additional time or money.

Should You Choose an S Corp Status for Your LLC?

Choosing to elect S corporation status for your LLC often comes down to a simple calculation at lower incomes. If you’ll save more money from the tax benefits of the election than you’ll spend on the increased costs to maintain the entity, it’s often worth it.

However, the decision becomes increasingly complicated the higher your earnings are and the more income streams you have.

For example, if you have W-2 wages from a job with another employer, it may reduce your self-employment tax savings from electing S status.

Ultimately, making changes to your small business’s tax treatment is a significant decision and can have repercussions beyond the scope of this article. As a result, you should always consult with your CPA before filing the election.

Using software to generate your financial statements makes tax time much easier for you and your accountant. Fortunately, Lendio offers a free small business accounting app. Give it a try today!

*The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.