Traditional corporations, sometimes called C corporations, pay income taxes at their corporate rates. When C corporations distribute dividends to shareholders, the shareholders also pay taxes on the dividends at their individual tax rates. S corporations avoid this double taxation because they do not pay taxes on most types of income. Instead, profits and losses flow through to the S corporation shareholders' personal returns. Despite the use of the word corporation in the name, a limited liability company can elect to be taxed as an S corporation.
Default Tax Classifications
Unless an LLC files an election to choose a different classification, the IRS will assign a tax classification under its so-called default rules. The default rules classify a single-member LLC as a disregarded entity (sole proprietorship) and an LLC with two or more members as a partnership. Both default classifications enjoy pass-through tax treatment (no tax at the LLC level).
If the default classifications allow limited liabilities to avoid double taxation, then why choose S corporation status? Business owners should only make that decision with the advice of a certified public accountant. CPAs often recommend an S election for an LLC when they expect that classification will reduce self-employment taxes. So long as an S corporation pays "reasonable compensation" to its owners for their services to the company in accordance with IRS regulations, the LLC can distribute earnings above those salaries to the members free of self-employment taxes. The S corporation may also qualify for deductions not available to partnerships.
Electing S Corporation Status
Qualified LLCs can choose S corporation status by filing a Form 2553 Election by a Small Business Corporation with the IRS. The IRS rules for making an LLC an S corporation are called check the box rules because the business can essentially check a box on a form to apply for the classification. Form 2553 must be filed no later than two months and 15 days after the beginning of the year in which the election is to take effect.
S Corporation Qualifications
Only limited liability companies with allowable owners can choose S corporation status. Allowable shareholders include individuals and certain trusts. Partnerships, corporations and non-resident aliens cannot own S corporation shares. The company cannot have more than 100 owners or more than one class of stock. IRS rules also prohibit certain types of businesses from using the S classification (including certain financial institutions and insurance companies).
Maintaining S Election
Even if the LLC meets all S corporation requirements at the time it files the election, it must continue to meet those criteria at all times to avoid losing its S status. Unwary businesses may take an otherwise legal action that violates the S corporation regulations, such as issuing an equity interest to an unqualified shareholder. Changes to the LLC operating agreement can also create risks. Limited liability companies generally have some flexibility to assign different rights to each member, which could result in more than one class of equity in violation of IRS regulations.