As a small business owner, you have several options when it comes to choosing the legal structure for your business. One popular choice is to form a limited liability company (LLC), which provides personal liability protection for its owners while also offering flexibility in terms of taxation. However, there may come a point where it makes sense for your LLC to make an S-Corp election, which can provide significant tax advantages. In this post, we will discuss when it makes sense for your LLC to make an S-Corp election, provide a real-world example, and discuss potential pitfalls of making the S-Corp election.
When Does it Make Sense for Your LLC to Make an S-Corp Election?
The primary reason for an LLC to make an S-Corp election is to save money on self-employment taxes. When you operate your business as an LLC, you are subject to self-employment taxes on all of the business’s net income. However, when you make an S-Corp election, you can pay yourself a salary and take the remainder of the business’s profits as a distribution, which is not subject to self-employment taxes.
To determine whether it makes sense for your LLC to make an S-Corp election, you need to calculate the potential tax savings. If your business generates a significant amount of net income, you may be able to save a significant amount of money by making the election. However, if your business does not generate enough net income, the tax savings may not be substantial enough to justify the additional costs and administrative burdens associated with making the election.
Real-World Example
Let’s consider a hypothetical scenario where you operate an LLC that generates $200,000 in net income per year. If you operate the business as an LLC, you would be subject to self-employment taxes on the entire $200,000, which would result in approximately $30,000 in self-employment taxes.
If you make an S-Corp election and pay yourself a reasonable salary of $100,000, you would only be subject to self-employment taxes on that amount, which would result in approximately $15,000 in self-employment taxes. The remaining $100,000 in profits would be taken as a distribution, which would not be subject to self-employment taxes.
In this example, making the S-Corp election would save you approximately $15,000 per year in self-employment taxes. This tax savings could be significant over time and would justify the additional costs and administrative burdens associated with making the election.
Potential Pitfalls of Making the S-Corp Election
While making an S-Corp election can provide significant tax advantages, it is important to be aware of the potential pitfalls associated with this decision. Some potential pitfalls include:
- Increased administrative costs: When you make an S-Corp election, you will need to file additional tax forms and maintain more detailed records. This can result in increased administrative costs for your business.
- Reasonable salary requirement: When you make an S-Corp election, you will need to pay yourself a reasonable salary. If the IRS determines that your salary is unreasonable, you could face penalties and additional taxes.
- Limited flexibility: When you make an S-Corp election, you will be subject to more restrictive rules than you would be as an LLC. This can limit your flexibility in terms of how you operate your business.
Making an S-Corp election can be a smart decision for your LLC if your business generates a significant amount of net income. By paying yourself a reasonable salary and taking the remainder of the business’s profits as a distribution, you can save a significant amount of money on self-employment taxes. However, it is important to be aware of the potential pitfalls associated with this decision and to consult with a tax professional before making the election.
Dearden Law 