The limited liability company (LLC) is a popular entity choice for many new businesses because it limits the liability of its members (like a corporation) and provides a great deal of flexibility for its members to determine the business arrangement (like a partnership). This flexibility extends to the preferred tax treatment of the LLC. By default a single-member LLC (SMLLC) will be treated as a disregarded entity and an LLC with multiple members will be treated as a partnership for federal income tax purposes. Under the check-the-box rules, however, an LLC can also elect to be classified as a corporation for federal income tax purposes. Those same rules also allow LLC’s to elect to be taxed under the S corporation rules. While both partnership and S corporation tax treatment provide that LLC income is passed through to its members, differing treatment with respect to employment taxes may lead some LLC’s to make the S election and forego partnership treatment.
Employment Tax Benefit
Each member of an LLC taxed as a partnership is subject to self-employment taxes on his or her distributive share of partnership net income. For 2015, self-employment taxes (equivalent to social security and medicare payroll taxes) are imposed at a combined rate of 15.3% of the first $118,500 of a member’s net income and an additional 2.9% on any amount over $118,500. Additionally, a medicare tax of 0.9% is imposed separately on the amount of net income over a certain threshold ($200,000 for single taxpayers and $250,000 for married filing jointly taxpayers). For an LLC with a substantial amount of income, these self-employment taxes can add up.
Shareholders of an S corporation, on the other hand, are not subject to self-employment taxes on the income distributed from the S corporation. Rather, an S corporation is subject to the typical payroll taxes on its employee wages. Employee-shareholders such as company officers, however, are required to receive “reasonable compensation” for their services to prevent such individuals from accepting payment via distributions and avoiding this employment tax liability. Employee-shareholders are subject to employment tax only on their wages, not on their share of the company’s income.
In the context of an LLC that has the option to be taxed as a partnership or make an S election, members could realize some tax benefit if they make the S election and draw a salary from the LLC that is less than their share of net income from the LLC. The amount of this tax savings will vary depending on the LLC’s income and the compensation to the member. As mentioned, the salary paid to an employee-member of the LLC is required to be reasonable. This “reasonable compensation” is determined based on a number of factors including:
- Employee qualifications
- Nature, extent, and scope of the work
- Size and complexity of business
- Prevailing economic conditions
- Employees compensation as a percentage of both gross and net
- Employee-member’s compensation compared with member distributions
- Employee-member’s compensation compared with non-member employee compensation
- Salaries for comparable positions with the market or industry
In the case of a professional services firm where income is heavily based on services provided by the owners, one would expect reasonable compensation to represent a higher proportion of the overall income of the company. Alternatively, if the business activities are highly dependent upon deployment of capital or equipment, reasonable compensation may be lower in proportion to net income generated by the business.
When assessing the benefit of potentially reduced employment taxes, LLC members must also be aware of the withholding and reporting requirements that will apply if an S election is made. In the case of an LLC with no current employees (and no current payroll system), withholding and reporting compliance may reduce or eliminate any employment tax savings associated with making the S election.
The S election will also subject the LLC to the comparatively complex, rigid rules governing S corporations. Importantly, S corporations are limited in the type and number of shareholders allowed. An LLC that makes an S election cannot have corporations, partnerships, or non-resident alien individuals as shareholders. Another important limitation is the single class of stock rule. S corporations are prohibited from issuing multiple classes of stock that confer different liquidation or distribution rights to holders. Different voting rights, however, are permissible.
Conformity with this rule can potentially limit one of the major benefits of the LLC – flexibility in structuring the business arrangement between the members. LLC operating agreements commonly contain special allocations of income or loss, and distribution or liquidation provisions that treat members differently. This flexibility to define the business arrangement between the parties often reflects varying amounts of capital, services, or other contributions each member has or is willing to make to the venture. An LLC that makes an S election cannot include any special allocation, distribution, or liquidation provisions that treat members differently. Each member will be required to receive allocations of income, loss and other tax items, as well as distributions and liquidations, in accordance with their respective interests in the LLC (capital account balances).
In analyzing whether an S election should be made, LLCs should be cognizant of the benefits and burdens association with taxation under Subchapter S of the Internal Revenue Code. First, a reasonable estimate of the potential employment tax savings should be made. This will depend upon the anticipated net income of the LLC, and the reasonable compensation paid to members that perform services for the LLC. Note that this tax benefit may be reduced by the added complexity of payroll tax withholding and reporting requirements. If a reasonable benefit or tax savings warrants further consideration, the LLC’s members should determine whether the LLC currently has or anticipates any activities or events that may disqualify it from making an S election. This includes ineligible members (e.g. corporations and partnership) or special allocations or differing distribution and liquidation rights among the members. Overall, an LLC S election may be an effective way to produce significant tax savings, but is only suited to certain businesses and ownership groups that fully appreciate the increase in complexity and rigidity associated with the election.
If you would like assistance in assessing or executing an S election for your LLC, please contact us at (210) 228-9500.