You have decided to start a business. You have researched Limited Liability Companies and S-Corps. Both have their advantages. But, how do you choose which one is better for you? Actually, you may not have to choose. You can have the best of both worlds by electing S-Corp status for your LLC.
If you choose this election, following the formation of your LLC, you must file Form 2553 “Election by a Small Business Corporation” with the IRS. Electing S-Corp status permits the company to pass corporate income, losses, deductions and credits through to its owners for federal tax purposes. Form 2553 may be filed at any time during the tax year preceding the tax year the election is to take effect and no more than two months and 15 days after the beginning of the tax year the election is to take effect.
From a legal standpoint, your company is an LLC. Therefore, you will have the benefit of ease of administration – fewer filings, fewer forms, fewer start-up costs, and fewer formal meetings and record-keeping requirements.
From a tax perspective, your company will be treated as an S Corporation. You will still have the pass-through of income, avoiding double taxation, same as if your LLC was treated as a proprietorship or partnership. Your company will exist separately and independently from you. The company can pay wages and salaries to its owners, which will be subject to FICA tax and other withholding requirements. Plus, it can distribute the remaining net earnings to the owners as passive dividend income, not subject to self-employment contribution tax.
But, be cautious when deciding how much to pay owners in salary verses dividends. The IRS has been cracking down on business owners who are electing to pay themselves through dividend income rather than wages. Compensation paid to the LLC owners must be reasonable to stand up to IRS scrutiny. To determine reasonableness, the Company must be able to answer “yes” to this question: Is the compensation what would be expected for an individual with the background and qualifications in other company’s of this size in this industry?