Both LLC’s and S-Corporations are “pass through” entities, meaning the profits and losses pass through the corporation to the shareholder(s), who claim profits and losses on personal tax returns. There is one great tax advantage to being an S-Corp over an LLC. In an LLC, the entity’s entire net income is subject to the 15.3% self-employment tax towards Medicare and social security. In contrast, an S-Corp owner/employee must pay the self-employment tax only on the salary that he gives himself. The remainder of the profits can be distributed to the shareholders free of the self-employment tax.
Of course, the shareholder/employee must pay himself commercially reasonable wages, otherwise the IRS will take notice and reclassify all the income as wages. Basically, the greatest benefit of being taxed as an S-Corp is the possibility of keeping some of the profits outside the scope of self-employment tax.
There are downsides to being an S-Corporation, including increased regulation of company procedures — required meetings, minutes, by-laws, stock transfers and records maintenance. A good basic rule is that LLC’s are better for companies who don’t expect much profit, but who are holding and protecting assets. S-Corps are better for companies who expect profits exceeding a reasonable salary and who are willing to go through the organizational requirements of being an S-Corp.
It is possible to have the advantages of simplicity, freedom and ease of use of an LLC combined with the tax advantages of an S-Corp. An existing LLC can request S-Corp status by making a special election with the IRS using form 2553, filed within the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. It is possible to file after this deadline by following special rules for making a late S-Corp election. There is a list of eligibility requirements that a company must meet to qualify for S-Corp status. These can be found at www.irs.gov/instructions/i2553/ch01.html
Filing as an S-Corp will save money for an LLC if they are expecting the coming tax year to have large profits, which will exceed a reasonable salary for that year. The LLC must be sure to recognize this potential for increased profits before the 16th day of the third month of the tax year, or else it will be too late to file form 2553.