Combining the Benefits of the LLC and the S Corporation
The LLC offers many advantages of flexibility in its ownership and management options. The Subchapter S Corporation offers lower tax rates for dividends and other qualifying distributions. Some businesses can reap the advantages of both business forms.
An accompanying article in this section of our website describes the advantages of a limited liability company form of legal entity over the Subchapter S Corporation. See COMPARING SUB S CORPORATIONS AND LLCs. As noted in that Article, the several significant advantages the LLC offers when compared to the Subchapter S Corporation can be easily overcome in the minds of many as to one important feature: Subchapter S Corporation shareholders can obtain lower tax rates on dividends and other qualifying distributions. By itself, the LLC does not offer this important feature.
An LLC Member may, however, have his cake and eat it too by electing to have the LLC treated as a Subchapter S Corporation for tax purposes. This is actually a fairly easy election to make; the Member simply arranges for timely filing of IRS Form 2553 with the Internal Revenue Service. In most cases, this filing will enable the LLC Members to reap the benefits of obtaining “dividend treatment” for some dividends and distributions which are made to the owners.
By this device, the LLC Members obtain a favorable mix of the two entities: reduced administrative duties and potentially lower taxes. You still have to file the necessary tax returns, but that is easier to take when your taxes are reduced.
This strategy enables LLC Members to divide their earnings between wages and “passive income” which is paid as owner distributions. The wages, salaries, and benefits are subject to the higher income tax rates and FICA taxes; the owner distributions receive the more favorable dividend treatment favored by physicians, other professionals and business owners. The benefits of this arrangement are obvious.
Like most things in law and life, however, this preferred arrangement is not risk-free or automatic. Members who work for the LLC must pay themselves a reasonable salary. For example, they cannot just pay themselves a $25,000 salary for work which ordinarily is hired at $100,000 per year, and then pay a $150,000 distribution on top of that at the lower tax rates. The salary paid in this circumstance must be “reasonable,” as that term is defined by the IRS and applicable law. Any division of pay which significantly deviates from this formula will be subject to strict scrutiny and potential penalties by the IRS.
This strategy is most effective when businesses and professional practices can pay a fair and reasonable salary to its Members throughout the year, and then pay a significant bonus or dividend at year’s end (or perhaps once or twice during the calendar year). Members who do not work for the LLC electing Subchapter S taxation are frequently in a stronger position to claim dividend treatment, but this is not always true. Much depends upon the make-up of the company, and its business activities.
Unfortunately, this strategy is not available to all who own an LLC. You should consult with our firm and your tax advisors before incurring the cost and effort needed to qualify your LLC as a Subchapter S Corporation for tax purposes.
Any accounting, business or tax advice contained in this Article is not intended as an in-depth analysis of specific issues, nor is it sufficient to avoid tax-related penalties. If requested, Lambert & Lambert PLC would be pleased to perform the requisite legal services for you under a separate engagement letter.
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