Before we answer the question of Should my LLC file the S Corp Election, let me say that there’s no one size fits all answer, the fact is there are many factors that must be taken into consideration such as type of business, the plans for the business and the short- and long-term goals of the owners.
The first question is what is an S Corp to begin with ? An S Corp is simply a company that elects to be taxed Subchapter S of the Internal Revenue Code, making it a “pass-through” entity for tax purposes. Otherwise, it’s a for-profit corporation, incorporated under and governed by the same state corporation laws as a C corporation. Because of this an S corporation offers similar liability protections, ownership, and management advantages as a C corporation.
Here are some of the advantages
One major advantage of an S corporation is that it provides the owners limited liability protection, regardless of its tax status. Simply put the owners’ personal assets are shielded from the claims of business creditors—whether the claims arise from contracts or litigation. In fact, all corporations, as well as LLCs, provide limited liability protection.
The tax benefit for S corporations is that business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level.
An S corporation owner can opt to receive both salary and dividend payments from the corporation. This can result in a lower tax bill overall. This is because dividends are not subject to self-employment tax. Further, the S corporation can deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders. However, the division between salary and dividends must be “reasonable” as determined by the IRS. (The IRS watches these types of transactions very closely and will step in and re-characterize the income if it feels the payments were unreasonable).
Should S corporation shareholders want to be taxed as a C corporation, all that’s required is filing this election with the IRS. An LLC that is taxed as a pass-through but wants to be taxed as a C corporation can also simply make a filing with the IRS.
Regardless of how you structure your business there are disadvantages.
In order to be eligible to make an S corporation election—and to continue to be an S corporation—the corporation must meet strict requirements on the number and type of shareholders and types of shares. These rules are imposed by federal tax law, and not state corporation law. Briefly stated, these rules include the following:
Only individuals, certain estates and trusts, and certain tax-exempt organizations can be shareholders
There cannot be more than 100 shareholders (although some family members can be counted as a single shareholder)
There can only be one class of stock (although differences in voting rights are permitted)
An LLC can be a pass-through entity without being subject to those restrictions. And although both an S corporation and an LLC are pass-through entities they are taxed under different sections of the Internal Revenue Code, so their taxation is not identical.
Because it is a corporation, an S corporation is required to allocate profits and losses among the owners based strictly on the percentage of ownership or number of shares held. In contrast, an LLC is able to allocate its profits and losses in whatever proportions the owners desire. For example the founding owner who transfers 50 percent of the ownership to a new member could receive a disproportionate share of the income from the LLC. In an S corporation, the founders' allocation is reduced from 100 percent to 50 percent.
It is important to remember that an S corporation is still considered a corporation. and it must observe all the corporate formalities imposed by its home state’s corporation statute. In contrast, the state LLC laws impose far fewer statutory formalities.