Taxing Your Single Member LLC as an S Corp

By default, the Internal Revenue Service (IRS) treats a single-member limited liability company (SMLLC) as a “disregarded entity.” This means the business’s profits and losses are reported on the owner’s personal tax return via Schedule C of Form 1040, and all net profit is subject to self-employment taxes. An SMLLC owner can elect to change this classification and have the business taxed as an S Corporation. This election only alters the federal tax treatment, not the LLC’s legal structure under state law, but it creates new rules for how the owner is paid and how profits are taxed.

Understanding the S Corp Tax Structure for an SMLLC

When an SMLLC is taxed as an S Corp, the owner also becomes an employee of the company for tax purposes. The IRS requires that any shareholder who provides services to the corporation must be paid reasonable compensation. This payment must be processed as wages through a formal payroll system.

This salary is subject to the same payroll taxes as any other employee’s wages. These are FICA taxes, consisting of Social Security and Medicare, which are split between the employee and the employer. The company pays the employer’s share, and the employee’s share is withheld from their paycheck. This is a departure from the default SMLLC structure, where the owner pays self-employment tax on all business profits.

After the owner’s salary and other business expenses are paid, any remaining profit can be passed to the owner as a distribution. These distributions are not subject to FICA or self-employment taxes. The owner will still pay personal income tax on these profits, but the absence of the 15.3% self-employment tax on this portion of the income is where tax savings are generated.

For example, consider an SMLLC with a net profit of $100,000. Under the default status, the entire $100,000 is subject to self-employment tax. With an S Corp election, if the owner sets a reasonable salary of $60,000, only that amount is subject to payroll taxes. The remaining $40,000 in profit can be taken as a distribution, which is not subject to self-employment taxes, creating potential tax savings.

Eligibility Requirements for the S Corp Election

To elect S Corp tax status, an SMLLC must meet criteria set by the IRS. The business must be a domestic entity, meaning it was formed and organized within the United States.

The owner, who is considered a shareholder for S Corp purposes, must also be eligible. An eligible shareholder must be an individual, a certain type of trust, or an estate. Partnerships, corporations, and non-resident aliens are not permitted to be shareholders.

Finally, the entity must have only one class of stock. While LLCs do not issue stock, this rule applies to the economic rights of the members. For an SMLLC, this is not a concern as there is only one owner. The rule prevents complex ownership structures where different members have different distribution or liquidation rights.

How to Make the S Corp Election

Information and Form Preparation

The election is formally made by filing Form 2553, “Election by a Small Business Corporation,” with the IRS. Before filling out the form, you must have the following information available:

• The LLC’s legal name, mailing address, and Employer Identification Number (EIN)
• The date the LLC was formed and the state of formation
• The desired effective date for the S Corp election
• The owner’s name, address, and Social Security Number

Completing the form involves entering these details, selecting the corporation’s tax year, and specifying the election’s effective date. You must also sign and date the form to confirm your consent.

The Filing Process

The timing of the submission of Form 2553 is governed by strict deadlines. To have the election take effect at the start of a given tax year, the form must be filed no more than two months and 15 days after the beginning of that tax year. For a business using the calendar year, this means filing by March 15 for the election to be effective as of January 1 of that same year. Alternatively, the election can be filed at any point during the preceding tax year.

Once completed and signed, the form must be sent to the correct IRS service center. The specific mailing address or fax number depends on the state where the business is located, and this information is available in the Form 2553 instructions.

After filing, the IRS will review the election. If it is approved, you will receive a confirmation notice, a CP261 Notice, from the IRS within 60 to 90 days. For those who miss the filing deadline, the IRS provides procedures for late election relief, which requires showing reasonable cause for the delay.

Ongoing Compliance and Responsibilities

Electing S Corp status introduces new administrative duties, the primary one being the requirement to run a formal payroll system. As an owner-employee, you must receive your salary through payroll, which involves withholding income taxes, Social Security, and Medicare taxes. These withheld amounts, along with the employer’s share of payroll taxes, must be remitted to the IRS. This also requires filing quarterly payroll tax returns, like Form 941, and an annual federal unemployment tax return, Form 940.

The annual business tax filing process also changes. Instead of using a personal Schedule C, the S Corp must file a separate informational corporate tax return using Form 1120-S. This return reports the company’s income, deductions, and profits for the year. The filing deadline is March 15 for calendar-year businesses.

From Form 1120-S, a Schedule K-1 is generated for the shareholder. This form details your share of the S Corp’s financial items, including your salary and any distributions. You will use the information from the Schedule K-1 to complete your personal income tax return, Form 1040, where the income is taxed at your individual rate.

The IRS requires the salary paid to S Corp owners to be reasonable, and you must be prepared to justify the amount. Factors that determine reasonableness include your duties, experience, time devoted to the business, and what comparable businesses pay for similar services. It is important to document how you arrived at your salary, as the IRS may reclassify distributions as wages if it deems the salary too low, which can lead to back taxes and penalties.