Good problem to have - Electing S Status

People often start their businesses as an LLC because it is slightly easier to run than a corporation. Sometimes the business becomes very successful and the accountant tells the owners they should have their LLCs taxed like an S-corp to save on taxes.

It is easy to elect S-status – you file a form with the IRS – but why?

The primary reason for a company to do this is because it wants the operational and organizational flexibility of the LLC, but it also wants to reduce self-employment taxes. This is an extremely cumbersome method of doing business and accounting.

I am a firm believer in the KISS principle (Keep It Simple, Stupid). If you want your business to be taxed as an S-corporation, why not just use a corporation rather than a limited liability company? Or start as an LLC and when you are making so much money it makes sense to be taxed as an S-corp, why not convert the entity? This is a good problem to have.

The LLC entity eliminates many of the formalities that a corporation must observe to preserve its corporate status. The LLC does not require bylaws, a board of directors, annual meetings, or minutes, for example.

But electing to be taxed as an S-corporation takes away much of this benefit.

To be taxed as a small business corporation, all the members of the LLC must meet the requirements of S-corporation shareholders. There cannot be more than one class of membership interests or more than 100 members, and the members cannot be corporations, partnerships, LLCs, or non-resident aliens. In addition, the S-corp must comply with all the withholding and reporting requirements of an employer, which is not necessary if an LLC has no employees other than its members. It will also have to make quarterly estimated tax payments. The entity will have to file a tax return itself, whereas the LLC does not necessarily file a return at the entity level.

In addition, the partnership tax provisions of the LLC operating agreement must be replaced with corporate tax provisions. This is high-level tax lawyering and could be expensive.

In my experience, owners of a hybrid LLC that is taxed like a corporation don’t understand if they are shareholders or not. They don’t know how to sign documents. This is understandable because they are a combination of two entities and in some cases, neither fish nor fowl.

If you need to be an S-corp for tax reasons, I strongly recommend converting to a corporation instead of straddling the swamp between the two kinds of entities.