For many small businesses operating an active trade or business, an election to form an LLC taxed as an S Corporation makes the most sense. It has several advantages, including limited liability, only one level of taxation, and minimal corporate formalities and other legal maintenance requirements. When compared to an LLC taxed as a partnership or disregarded entity, an S corporation can often save the owner(s) a significant amount of FICA taxes on an annual basis.
But an S corporation is also subject to significant limitations: it can have no more than 100 shareholders, most entities and certain trusts cannot be shareholders, corporate profits must generally be divided amongst the owners on a pro rata basis, and it can only have one class of stock. In addition, unlike the single member LLC taxed as a disregarded entity, the sole owner of an S Corporation must generally pay himself or herself a wage and is therefore subject to payroll reporting. Lastly, an S Corporation is typically not a good vehicle to own passive investments such as most rental real estate. A single member LLC treated as a disregarded entity can generally avoid a separate income tax return from its owner. As a result, an S Corporation may carry with it additional tax preparation expenses and other ongoing costs that a disregarded entity may not incur.
In our experience, the costs associated with maintaining an S election may be appropriate for a single-member LLC that meets the S corporation eligibility requirements above and generally produces (or is expected to produce) more than $60,000 (or so) of annual net taxable income from an active trade or business. While an S election may be the right fit, a business owner should first evaluate the limitations and costs applicable to an S Corporation, particularly those relating to investor limitations and tax preparation fees.
For the most part, once the election has become effective, it cannot be revoked until the next taxable year. Once the election is effective, you must file the tax return for an S Corporation and be subject to the other applicable S Corporation regulations. While there is some discretion for the IRS to accept a revocation of the election, this is not guaranteed and may preclude another election being made for the entity for up to five years.
Before making any entity choice, you should weigh all restrictions and expenses associated with your selection. Some choices, like an S election, may be unable to be immediately undone.
By Hannah K. Fischer of BairdHolm