Elite Tax Status, Payment Methods, and More…
Upgrading to a specialty tax status changes how you and your taxes are paid. When you upgrade your LLC to a specialty tax status, you and any other owners are referred to as “Shareholders” instead of as “Members”.
Here are the two options you can choose from:
|Payment Method||Owners Draw||Salary + Distributions||Salary + Dividends|
|Tax Advantages||None||No Corporate Tax||No Self-Employment Tax|
Upgrading has the potential to save you, and the rest of your company, money by using the unique characteristics of these business entities. The downside of upgrading is your LLC will have different rules, regulations, and taxes to file. Not only is it a new system, but it’s also more complex.
By electing an S- or C-Corp status, your LLC is first taxed as its own business entity. Whatever remains is taxed again as personal income to the Owners and Shareholders.
The Default LLC’s simplicity is the biggest advantage over Specialty LLCs.
Upgrading before your business has the capacity to follow higher maintenance and regulatory requirements can cause you to miss out on the tax benefits.
There’s no rush.
If you’re not fully established yet, you could miss out on everything that makes S- and C-Corps worth your while.
You can upgrade your default LLC to an S-Corporation where owners get paid a combination of a Salary and Distributions.
The S-Corp is generally more popular because you avoid Corporate Tax. The funny thing is Pass-Through Taxation also gets you out of Corporate Tax but without all the extra rules and regulations.
Just remember: Your LLC should be consistently profitable before upgrading.
Benefits of an S-Corporation
Some states limit the amount of profits Members can take in a default setup.
In an S-Corp, however, there is no limit on how much of the LLC’s profit you and the rest of the Shareholders can receive.
You can optimize your income in an S-Corp and pay less tax by splitting your earnings between salary and distributions.
In a default LLC, Members are only paid in Draws/Distributions.
Since owners contribute to the business, you are exempt from paying Self-Employment Tax on your employee Salary.
The company pays Social Security and Medicare taxes (i.e. Self-Employment Tax) on everyone’s salary.
Being that you are both an Owner and a Shareholder, you’re paying Self-Employment tax on all your Distributions.
The process is very similar to how an employee pays taxes on a salary.
The difference with owners is only their distributions undergo Self-Employment tax, their salaries are exempt.
How you’re taxed depends on whether you work “for” the company or work “on” your company.
To upgrade to an S-Corporation:
- The IRS limits S-Corps to 100 shareholders
- Shareholders must be US citizens residing in the United States
- Owners can only be people (Not groups, organizations, or other business entities, as they can be in a default LLC)
- Owners must have the same class of stock. Certain shareholders can’t have a higher status or more entitlement than other shareholders
These additional rules create more uniformity within the LLC.
S-Corp Election Forms and Tax Forms
To upgrade your default LLC to a specialty S-Corp, complete and file a 2553 Election Form.
➤ MORE: Upgrade to an S-Corp.
Thankfully, there are plenty of online services available to submit these forms and other documents on your behalf. They simplify the process and reduce the headache of dealing with government services and bureaucracy.
Once you’re operating as an S-Corp, you’ll use an 1120-S Form to file taxes. This form is similar to the form full-on Corporations use to file taxes.
S-Corp in Action
Let’s say Sarah is a freelance graphic designer, who wants to upgrade her business to an S-Corp. Here’s how she could make the best use of an S-corp’s unique features:
1. Tax Benefits As an S-Corp, Sarah can enjoy tax benefits.
Instead of being taxed at the corporate level like a regular C-Corporation, the income generated by the S-Corp “passes through” to Sarah as the owner, and she reports it on her personal tax return.
This avoids the double taxation that C-Corporations may face.
2. Limited Liability Protection: By forming an S-Corp, Sarah gains personal liability protection.
This means that her personal assets are separate from the business’s liabilities.
If the business faces legal issues or debts, Sarah’s personal assets, such as her house or savings, are generally shielded.
3. Credibility and Perpetual Existence: Establishing an S-Corp can enhance Sarah’s business credibility.
Having “Inc.” or “Corp.” after her business name indicates a formal structure, which may appeal to clients and partners.
Additionally, an S-Corp can have perpetual existence, meaning that the business can continue even if Sarah decides to step away or sell her shares.
4. Employee Benefits: As an S-Corp owner, Sarah can receive compensation as a combination of salary and dividends.
She can pay herself a reasonable salary, which is subject to payroll taxes, including Social Security and Medicare.
Additionally, Sarah can receive dividends from the company’s profits, which are not subject to self-employment taxes, potentially resulting in tax savings.
5. Easy Transfer of Ownership: If Sarah wants to bring in partners or transfer ownership to others in the future, an S-Corp structure allows for flexibility.
Ownership interests can be transferred through the sale or transfer of shares, simplifying the process of adding or removing owners.
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It’s important to note that forming and maintaining an S-Corp requires compliance with legal and regulatory requirements, such as filing articles of incorporation, holding shareholder meetings, and maintaining proper corporate records.
Seeking guidance from a qualified attorney or accountant is recommended to ensure adherence to applicable laws and regulations.
You can also upgrade your LLC to the specialty C-Corp tax status.
Benefits of C-Corporation
In addition to the salaries, you and the rest of the owners receive Dividends.
Shareholder Dividends are considered personal earnings and are taxed a second time.
This tax is based on your tax bracket so it varies from one person to the next.
Dividends are subject to Self-Employment Tax because only Owners get them.
There is no Self-Employment tax on salaries for either owners or employees.
Even though upgrading to a Corporate Tax Status means paying Double Taxation, one thing you are getting out of is having to pay Self-Employment Tax for your salary, as we just mentioned above.
Double Taxation incentivizes owners to recirculate Dividends within the company.
By keeping this money in the business, you are not taxed a second time.
Dividends left in the business’s account are still subject to Income Tax, even when nobody claims the money.
The drawback of going C-Corp is your company is required to pay taxes twice.
This is what’s referred to as “Double Taxation”.
The first tax is the 21% Corporate Tax which applies to all company profits.
Your LLC pays Corporate Tax as its own entity.
After paying the Corporate Tax, your LLC pays salaries to you and the other shareholders based on everybody’s proportional contributions to the business.
C-Corp in Action
Let’s consider a quick example where Alex, an entrepreneur, decides to upgrade his tech startup to a C-Corp.
Here’s how he utilizes the special features of a C-Corp:
1. Fundraising and Investment: Alex can raise capital for his startup by seeking investments from venture capitalists and angel investors.
C-Corps are often preferred by investors because they can issue multiple classes of stock, allowing for different levels of ownership and preferred rights.
This flexibility in ownership structure makes it easier for Alex to attract investors and raise funds for his business.
2. Limited Liability Protection: By forming a C-Corp, Alex gains personal liability protection.
This means that his personal assets are typically separate from the liabilities of the business.
If the startup faces legal issues or debts, Alex’s personal assets, such as his house or savings, are generally shielded.
3. Perpetual Existence: A C-Corp can have perpetual existence, meaning that the business can continue even if Alex decides to step away or sell his shares.
This can provide stability and continuity to the startup, even in the event of changes in ownership or leadership.
4. Employee Benefits: C-Corps can offer various employee benefits, such as health insurance, retirement plans, and stock option plans.
Alex can provide competitive compensation packages to attract and retain talented employees, as well as incentivize them through stock options or equity participation, which can align their interests with the long-term success of the company.
5. Tax Planning and Deductions: While C-Corps are subject to double taxation, meaning that the corporate profits are taxed at the corporate level, and any dividends distributed to shareholders are taxed again on their personal tax returns, they can still provide certain tax advantages.
C-Corps have more opportunities for deductible business expenses and can potentially benefit from lower corporate tax rates and deductions not available to other business structures.
6. Exit Strategies: With a C-Corp, Alex can make his startup public through an initial public offering (IPO) or look for buyers.
Public investors and potential acquirers deal with C-Corps regularly, making it easier to navigate such transactions.
It’s important to note that forming and operating a C-Corp involves complying with legal and regulatory obligations, such as filing articles of incorporation, holding regular shareholder meetings, and maintaining proper corporate records.
Seeking guidance from professionals, such as attorneys and accountants, is crucial to ensure compliance and maximize the benefits of a C-Corp structure.
C-Corp Election Forms and Tax Forms
To upgrade your LLC to the specialty C-Corp tax status complete an 8832 Entity Classification Election Form and submit it to the IRS.
➤ MORE: Upgrade your LLC to a C-Corp.
Once you’re all set up with your C-Corp you’ll use an 1120 Form to file taxes. This is the same form Corporations use to file taxes.
➤ MORE: Filing taxes as a C-Corporation.