After establishing a business, individuals often face an unexpected question – How do they want their newly formed entity Taxed? This question is unexpected, as many individuals simply pay the state fee to form their organization but do not create governing documents or make all available tax elections. While making these elections is not always mandatory, not doing so can cause you to be at a tax disadvantage.
What are my choices?
The tax choices available to you depends on the kind of entity you have set up. The IRS has two major tax structures available to businesses, these are Corporations and Disregarded Entities. The IRS recognizes that Corporations exist and treats them as taxpayers. Additionally, certain corporations can elect to be taxed as “S-Corps” which removes a layer of taxation.
Disregarded entities are everything else, this includes Partnerships and by default, LLCs. If you are a partnership, then you must be taxed using the partnership tax code. However, if you are an LLC, you have a choice to make. You get to tell the IRS which set of rules you want to apply to your entity, the partnership tax rules, or the corporate tax rules. If you elect the corporate rules, then you can also make an election to be an “S-Corp.”
What’s an S-Corp?
As mentioned above, the IRS recognizes corporations as their own entity. This comes with one major drawback; since they are recognized as a taxpayer by the IRS, corporations have a layer of tax imposed on their profits, meaning that there are “two layers” of tax, one at the corporate level, and one on the personal level. As when the corporation pays out dividend to the shareholder, the money would be subject to additional tax. However, if you meet certain criteria, you can qualify for “S-Corp” status. If you qualify for S-Corp status, then the entity is not taxed, instead, similar to partnerships, the profits of the corporation are allocated among the shareholders and taxed at the individual level. However, how those allocations are made is fixed, and rather rigid.
So an S-Corp can be an LLC?
Yes. The IRS lets you choose how you want to be taxed when you set up an LLC. This is one of the many reasons we generally recommend a new business organizes as an LLC. However, you must keep in mind that the general criteria needed to be an S-Corp, must be met by the LLC in order to make that election. Those criteria include, among others, having less than 100 stakeholders own the LLC and only having one class of stock/share/unit.
Should every LLC ben an S-Corp?
No. While each situation is different and merits examination, generally speaking, electing S-Corp status is recommended when one is actively participating in an active business. Making the election would generally not be recommended if you are forming an LLC to simply hold realty. Additionally, if you wanted to create a complex LLC that had various types of membership classes and a complicated distribution scheme, the entity you create may not be eligible to be an S-Corp. Keep in mind that making an S-Corp election comes with certain restrictions and duties, you must make sure that you are aware of what you sign up for, and to follow the rules. If you do not follow the set rules, you could “blow” your S-Corp election and end up taxed as a regular corporation, or “C-Corp”, with two layers of tax.
Can I switch?
Generally speaking, yes you can; however, as with everything in life, there are consequences. Making this conversion is complex and generally requires the advice of competent counsel as well as an accountant. There are major consequences tied to switching tax regimes, and this decision needs to be well thought out and carefully planned. You can avoid the hassle and expense of making this conversion by making the adequate choices when forming your entity.