Under the “check the box regulations” a US Limited Liability Company (LLC) may elect to be treated as an S Corporation. But making the election by filing the relevant forms does not guarantee that you meet the requirements for S Corp treatment.
Below is some key information that everyone with an LLC should know about making the S Corp Election.
Why Make The Election?
The typical person collecting a paycheck from an employer pays half of their Social Security and Medicare taxes while their employer pays the other half (each pays 7.65% for a total of 15.3%). These are called “FICA taxes.”
But self-employed individuals are responsible for paying both the employee part of the Social Security and Medicare taxes and the employer portion as well (15.3%). This is called the self-employment tax.
This remains true if you own and actively participate in the business of an S Corp and are not an employee thereof.
However, it’s possible for someone that owns an S Corporation to also be an employee. Assuming he is paid a “reasonable salary,” the owner/employee can avoid self-employment and FICA taxes.
Here’s how it works – the S Corp would pay 50% of the owner/employee’s FICA taxes and the employee would pay the other half. The S Corp’s profit, in this case, is not considered earned income and is not subject to self-employment or FICA taxes.
S Corp Definition
Section 1362 of the tax code requires that S Corps only have “one “class of stock” as defined by the accompanying treasury regulations.
For federal tax purposes, a corporation has only one class of stock if all of its outstanding shares have “identical rights to distribution and liquidation proceeds.”
Different rights in these regards mean that the corporation has multiple classes of stock and is therefore not an S Corp.
One common complication is that Operating Agreements for LLCs can often inadvertently disqualify a successful S Corporation election.
Most people use boilerplate Operating Agreements when they form their LLC. These are readily available for free online and are also used by the cheap high-volume entity formation mills.
Off-the-shelf Operating Agreements typically contain clauses that in effect state that upon dissolution and liquidation, proceeds will be distributed according to the members based on their capital account balances and (if any remains) in accordance with their percentage interests.
Such boilerplate language exists because a different part of the tax code requires that partnership agreements must meet “substantial economic effect” provisions and that section’s treasury regulations demand that distributions be on the equivalent of a “per share” basis in all situations.
And since LLCs are usually taxed as partnerships, boilerplate operating agreements generally contain the partnership language rather than the S Corp language.
No Distribution Is Required
The IRS will deny an S Corp election if the LLC’s Operating Agreement simply allows for a disproportionate distribution to occur but does not require that one ever does.
The possibility of one is enough to be denied S Corp treatment.
Typically, people make the S Corp election and assume that everything is fine. Their ineligibility is only discovered after they’re audited years later.
Penalties and interest will apply for every year the incorrect tax return was filed and can add up quickly.
It’s critical to make sure that your LLC’s Operating Agreement suits your needs because fixing a mistake is very costly and time consuming.
Taxpayers must file for a Private Letter Ruling (PLR) and gain the IRS Commissioner’s determination that the conditions disqualifying an S Corp election were inadvertent.
This is a costly and time-consuming process with no guarantee of success. That’s why it’s critical to make sure that your LLC’s Operating Agreement suits your needs.
Esquire Group can help you form a new entity with these complications in mind.
We also have the ability to modify the Operating Agreement of an existing entity to ensure the success of your S Corporation election.
Schedule your consultation NOW!