Electing your LLC to be Taxed as an S-Corporation
Preface: LLC’s can be taxed as disregarded entities, partnerships or corporations. This blog outlines the initial parameters on an LLC taxed as a partnership electing to be taxed as an S-Corporation
Typically limited liability companies (LLCs) are taxed as partnerships or disregarded entities. Yet, LLCs can also be taxed as S-Corporations too. One reason a tax advisor may suggest S-Corporation taxation for your LLC is the savings on the self-employment taxes assessed on the partnerships distributive share of income. This tax can be avoided in an S-Corporation. Let’s say your distributive share of business earnings are $400,000 a year. If you distribute the $400,000 in partnership earnings, you would be subject to self-employments taxes on that distribution balance. An additional tax that easily could exceed say $15,000 per year. With an S-Corporation election for your LLC, you would not be subject to these additional taxes on distributions.
Making the choice to convert your LLC to S-Corporation needs to be a calculated tax decision. Why? Because S-Corporations have multifarious rules that partnerships are not subject to. Converting your LLC taxed as a partnership to an LLC taxed as an S-Corporation requires the following steps.
LLCs are typically initially formed with an operating agreement designed for partnership tax. If you convert your LLC to be taxed as an S-Corporation you will need an attorney involved with the tax conversion to modify or amend partnership provisions in the operating agreement to be consistent with those of a corporation. These amendments include single class of stock requirements, equal rights to distributions and liquidation, terminology of stock instead of say units, removal of Section 704 partnership language including qualified income offsets and minimum gain charge backs, and updates to the buy-sell agreement.
The election is relatively easy; you simply file a Form 2553 Election by a Small Business Corporation with the IRS. The election implies that you have for authoritative tax statutes, transferred all your business assets and liabilities to the corporation in exchange for stock distributed to you. The 2553 should be filed within 75 days of when it is to be effective. For calendar year LLC this would be say March 15th. If you embark on an election with the Form 2553 without first amending the operating agreement, the election could fail. Your tax advisor should have a plan for safeguarding your business in the event of eligibility failure on the election. Converting back to a LLC taxed as a partnership can be expensive, requiring a sale of all assets at fair market value. This can result in significant capital gains tax on assets and goodwill.
The proper choice between partnership or S-Corporation taxation for your LLC may be more complex than originally thought. You should now appreciate that you need an experienced CPA and attorney to appropriately make an informed decision on the requirements for a proper assessment of a tax conversion of an LLC. The tax savings can be minimal to thousands of dollars per year, where applicable. If you are exempt from self-employment taxes with a Form 4029, you already benefit from these tax savings, and no benefit would be derived from a conversion. Other times the cost and work to convert the LLC exceed the tax savings benefits. If you are thinking of electing to have your LLC taxed as an S-Corporation, first talk with your CPA and attorney to determine the advantages.