In Part A we covered a Single Member LLC (SMLLC). In Part B we discussed a Multi-Member LLC (MMLLC). In Part C, the final part,  we are discussing S corporations. 

When you have an LLC it is possible to elect S corporation status. When you do this you are choosing to be treated as a special type of corporation, an S corporation, for tax purposes. Often states have different requirements for S corporations, so make sure to thoroughly research requirements before making a federal election. 

In the case of real estate rental activity  (in which the S corp owns the property), an S corporation is most often a BAD IDEA. This is for a variety of reasons. The tax ones can be very significant. If you are ever advised to elect S corp status for rental activity make sure you are very diligent in determining that it is the best course of action for your specific circumstances. It is NOT always a bad idea.  

What about for business activity? Some people will say that if you make a certain amount of money, then you should have an S corp instead of just a SMLLC or a MMLLC. But there is no good general thumb rule for the decision to elect S corp status. Let’s explore why you might want to elect S corp status. This is a simplified discussion so it does not include all considerations. Any decision to elect S corp status should only be done after careful consideration and due diligence and only after consultation with your knowledgeable tax professional and knowledgeable lawyer – knowledgable with entity selection and repercussions. 

If you earn a profit of 100k under a SMLLC, then you have 100K that is subject to income taxes and self employment taxes. If you have an S corp you can change some of that income from the activity from being earned income subject the to social security and medicare taxes (self employment taxes under a SMLLC) to being just subject to income tax and not subject to social security and medicare taxes (or self employment taxes). Generally speaking, if you are actively working in the S corp, then you have to not only have payroll but you have to  pay yourself as a W-2 employee.You have to pay yourself reasonable compensation for the work that you do as a W-2 employee. For example if you are the only member (shareholder) with no employees, this means if your reasonable compensation should be 70k then that is paid to you as a W-2 employee and the remaining 30K in our example income subject the ordinary income tax rate only. So your main savings from the S corp is that you aren’t paying self employment taxes on that 30K of income. 

As a side note there can be S corp situations where there is no payroll, because there is no profit. Or that the reasonable compensation is lower than it otherwise should be because there isn’t enough profit.  

Determining what your reasonable compensation properly is very important and is an area that has errors and is a common area of IRS audits and tax penalties. What drives or should drive the reasonable compensation determination is how would the work that you actually do be compensated for if you were an employee for someone else doing the same things. How much you would receive in wages. The IRS loves to look at how that was determined, because they often can impose a lot of taxes and penalties when they disagree with the taxpayer. 

Whether or not an S corp election is the best choice for a given situation includes more considerations than what we have discussed. While S corp income and losses are passed through to shareholders, there are S corp filing requirements. Having an S corp increases compliance costs, usually significantly. 

DIY S corp set up and tax preparation is not recommended. Good accounting and bookkeeping is vital for every S corp. This also tends to increase costs. 

You can establish a simpler LLC  when starting out and then elect S corp status later when it makes more sense. Whether or not you should start out as an S corp depends on the particular facts and circumstances of the tax situation and likely the legal situation. 

The IRS provides some information on S corps here. 

Free advice and information regarding an S corp election may be a starting point, but it is no substitute for professional advice. If you are going to consult someone regarding an S corp election please consider one of our members regarding the tax aspects of such an election.