LLC or S corporation taxation: when the election helps and when it costs you

It depends on profit, and on paying yourself properly

An S corporation election can make sense for an LLC that earns steady profit beyond what the owners would reasonably be paid as salary for the work they do. The usual reason owners consider it is that an S corporation's owner-employees pay employment taxes on their wages, while profit passed through above a reasonable salary is not subject to those taxes, whereas the net earnings of a single-member LLC or a partnership are generally subject to self-employment tax. The trade-off is that you must run payroll for yourself, pay a salary the IRS would consider reasonable, file a separate corporate return and meet the eligibility rules.

At Malnory, McNeal & Company, we prepare business and individual returns, help with new business formation and do year-round tax planning, and this is one of the most common questions owners bring us. My answer is always the same: run the numbers for your business, not someone else's. What follows is general information to help you have that conversation; talk to a licensed CPA before you file anything.

How an LLC is taxed if you do nothing

An LLC is a creature of state law, and the IRS does not have a separate tax category for it. According to the IRS, a single-member LLC is treated by default as a disregarded entity, so its income is reported on the owner's personal return, though it is still treated as a separate entity for employment tax and certain excise taxes. A multi-member LLC is treated by default as a partnership.

An LLC can change that default. It can file Form 8832 to be classified as a corporation, and an eligible entity can elect S corporation treatment by filing Form 2553. The IRS notes that a Form 8832 election generally cannot take effect more than 75 days before it is filed or more than 12 months after. Timing matters, and late-election relief exists only in some circumstances, so the decision belongs in planning before the year starts, not in a rush at filing time.

What actually changes after the election

An S corporation still passes income, losses, deductions and credits through to its shareholders, who report them on their personal returns. That avoids the double taxation a regular corporation faces. What changes is the paperwork and the way owners are paid.

The business files Form 1120-S each year and issues a Schedule K-1 to each shareholder. Owners who work in the business become employees for payroll purposes, which means withholding, payroll tax deposits and quarterly Form 941 filings, plus the annual Form 940 for federal unemployment tax. The owner's compensation is split into two pieces: wages, which carry employment taxes, and distributions of remaining profit.

The books have to support that split. Owners of a disregarded LLC often move money between business and personal accounts informally, and nothing breaks. After the election, every transfer to an owner is either payroll, a distribution or a reimbursement under a documented policy, and each is treated differently on the return. Shareholders also need to track their basis, which affects whether distributions and losses are taxable. Owners who are not ready for that discipline tend to create the very problems the election was supposed to avoid.

• A separate federal return, Form 1120-S, with a Schedule K-1 for each shareholder.
• Payroll for owner-employees, including withholding, deposits and quarterly and annual payroll returns.
• A reasonable salary for every shareholder who works in the business.
• Cleaner separation between business and personal money, because distributions and wages must be tracked.

The reasonable salary rule

This is where most of the risk sits. The IRS says that when a shareholder-employee provides services to an S corporation, the corporation must determine and report an appropriate and reasonable salary for that shareholder. Courts have held that shareholder-employees are subject to employment taxes even when they take distributions, dividends or other forms of payment instead of wages. In other words, you cannot pay yourself nothing in salary and take everything as a distribution.

What is reasonable depends on the facts: the work you do, the time you spend, what the business would pay someone else to do it, and the company's results. There is no single formula, and the number should be documented. When the reasonable salary is close to the business's total profit, the savings from the election shrink or disappear, which is why the election rarely helps a business with thin margins.

Getting owner pay wrong is one of the payroll problems I see most often, alongside late deposits and misclassified workers. I go through those in the payroll tax mistakes small businesses make.

When the election tends to make sense

In my experience, the election is worth a serious look when a business has consistent profit, a clear reasonable salary for the owner that is meaningfully lower than that profit, and owners who are prepared to run payroll and keep clean books. It is usually not worth it in the first year of a business with uncertain income, when the owners need every dollar of flexibility, or when the business is likely to have losses.

The test is concrete. Estimate next year's profit, estimate a defensible salary, and compare the employment taxes under each structure against the added cost of payroll processing, the separate return and the bookkeeping discipline the election requires. If the difference is small, the simpler structure usually wins. If it is large and recurring, the election may pay for itself many times over. A CPA who does tax planning can run that comparison with your actual numbers.

Eligibility limits and costs owners forget

Not every business can elect. The IRS lists the requirements: the corporation must be domestic, have no more than 100 shareholders, have only one class of stock, and have only allowable shareholders, which can include individuals, certain trusts and estates but not partnerships, corporations or nonresident alien shareholders. Form 2553 must be signed by all shareholders.

The one-class-of-stock rule surprises multi-member LLCs whose operating agreements give partners different economic rights, such as preferred returns or special allocations. Those arrangements can conflict with S corporation rules, so the operating agreement may need to change before the election. If you have business partners and nothing in writing about what happens when one leaves, settle that first; partners without a buyout agreement explains why.

• Payroll processing and quarterly payroll filings for the owners.
• A separate corporate return and the preparation cost that comes with it.
• Reasonable salary documentation each year.
• Less flexibility in how profits are divided among owners.
• Possible changes to the operating agreement to fit the one-class-of-stock rule.

The Texas side of the decision

Texas has no state personal income tax, so for Dallas owners the election is mainly a federal decision. That does not mean Texas is irrelevant. The Texas franchise tax applies based on how an entity is legally formed, not how it is treated for federal income tax, so an LLC owes the same Texas reports whether it is disregarded, taxed as a partnership or taxed as an S corporation. Many small LLCs owe no franchise tax but still have an annual report to file, which I cover in what a no-tax-due Texas business still has to file.

If your business operates in other states, their rules can differ, and some states treat S corporations differently from the federal system. Raise any out-of-state activity in your planning conversation.

Lenders are another practical consideration. When an S corporation owner applies for a mortgage or a business loan, the lender looks at both the personal return and the corporate return, including wages and distributions. Owners who keep salary artificially low sometimes find their documented personal income looks thinner than they expected. That is not a reason to avoid the election, but it is one more reason to set compensation thoughtfully.

Questions to settle before you elect

Bring these to your CPA. The answers decide whether the election helps, and they also prepare you for running the business as an S corporation if you go ahead. Write the answers down; next year's review is much faster when you can see what you assumed this year.

• What profit do we realistically expect next year, and how steady is it?
• What salary would be reasonable for each owner's role, and how will we document it?
• What will payroll processing and the separate return add to our costs?
• Does our operating agreement fit the one-class-of-stock rule?
• When should the election take effect, and what is the filing deadline for that date?
• How will this affect retirement contributions, health insurance and other owner benefits?

Working through it with a CPA

When an owner asks us about the S corporation election, we start with last year's return and the current year's books, then model the next year both ways. We look at reasonable compensation, payroll costs, the effect on the owners' personal returns and the timing of the election. If the numbers favor it, we can help with the election, set up payroll and handle the returns. If they do not, we will say so and revisit it when the business grows.

Our Dallas office works with owners across the Dallas–Fort Worth area, and we exchange documents through a secure client portal. Whatever you decide, make the choice deliberately, document it, and look at it again each year, because the right structure for a new business is not always the right one five years later.

Questions people ask me