Most people associate the S-election with a corporation. But other entities, including sole proprietorships, partnerships and limited liability companies, are also eligible for Subchapter S treatment. Electing Subchapter S treatment is a beneficial strategy for reducing employment taxes for many pass through entities.
I receive a lot of phone calls from small business owners who tell me that their CPAs recommended that they form an S-corporation. When CPAs suggests an S-corporation, they mean that you would be better off being taxed under Subchapter S and adding a layer of liability protection. The CPA doesn’t usually care what type of business structure you use.
Fortunately, you do not have to choose your business structure based on your desired tax classification. There are a lot of reasons why LLCs are usually better legal entities than corporations. The very short version is that they require less work and offer better creditor protection. And you can have the benefits of an LLC while also choosing how you wish to be taxed. You can make an S-election and have the best of both worlds.
Before making the S-election, you should carefully analyze the possible benefits. Your CPA can help you make that determination. For many small business owners, the S-election is beneficial because a portion of your income will not be subject to self-employment taxes. These taxes include the 12.4% Social Security Tax, the 2.9% Medicare Insurance Tax, and the 0.9% Additional Medicare Tax.
The S-election allows you to save on employment taxes because your earnings can be segregated between wages and distributions. Wages are subject to employment taxes, and distributions are not. So if your business is taxed under Subchapter S, you want to treat as much as you can justify as distributions instead of wages.
Unfortunately, there is no formula that explains how to do that. Neither the tax code nor the regulations give specific guidelines. Court rulings are very fact-specific. All we know is that wages have to be reasonable.
You will have to do the math to determine the savings of making an S-election. The savings can be significant. However, this strategy may not work for you, and it is important to involve an experienced lawyer or CPA when making the S-election. A cursory examination of eligibility and computing the potential savings are the essential first steps in employing the strategy. If made deliberately and with care, the S-election is a powerful strategy to reduce employment taxes. For many small businesses, an LLC combined with an S-election gives the best legal and tax structure.