Starting a business for the first time can be an exhilarating experience, but it also comes with many complicated decisions. One of these decisions is whether your limited liability company (LLC) should elect S Corporation status. On the surface, it may seem like a no-brainer to take advantage of the potential tax benefits this election can provide. However, as many small business owners have learned, pursuing S-Corp status isn’t always beneficial. In certain cases, you may even end up doing more harm than good. So let’s discuss when electing S-Corp status doesn’t make sense so you can make an informed decision about what’s best for your business.
Reduced Qualified Business Income Deduction
One of the main benefits of making an S Corp election is that it can result in lower self-employment taxes. Because S Corp owners are considered employees of the business, they don’t pay self-employment taxes on 100% of their share of business income like LLC owners do. Instead, the company issues them a paycheck and they only pay Social Security and Medicare taxes (the employed person’s version of self-employment taxes) on that amount.
Many small business owners (and even their advisors) base their decision to make an S Corp election solely on that reduction in self-employment taxes. However, their savings estimate often doesn’t consider the qualified business income (QBI) deduction.
The QBI deduction allows owners of certain pass-through businesses to deduct up to 20% of their business income. However, when you make an S Corp election, you’re converting part of your business profits to salary, meaning less income is eligible for the QBI deduction. This can make an S Corp election less beneficial than it initially looks on paper and lead an LLC owner to decide that it doesn’t make sense to elect S-Corp status.
As an S Corporation, you’ll have to run payroll and file quarterly payroll tax returns. For most small business owners, this means hiring an accountant or payroll service, which can cost anywhere from $40 to $60 per month for one employee to a few hundred dollars per month for a dozen or more employees.
You will also need to file a separate tax return for the S Corp. If you currently operate as a single-member LLC, you’re not filing a separate tax return for the business. Instead, you report business income and expenses on Schedule C, filing it with your personal tax return.
Filing a separate return for your business can result in significantly higher tax preparation fees, whether you use DIY software or hire a professional.
Revising Operating Agreement
You may need to revise your operating agreement if you plan on converting your LLC to an S Corp. Many LLC operating agreements contain language that can inadvertently result in the termination of the S election. If you don’t revise your operating agreement before making the election, it could end up being involuntarily terminated.
New Members Contributing Property
When members of an LLC contribute property to the business, it reduces the amount of money required to start and operate the business and helps to reduce overhead costs.
However, when a new member contributes property to an LLC that’s already elected S Corp status, the member may have to recognize a taxable gain as though they’d sold the property to the business.
LLC members may make special allocations of income or deductions for a variety of reasons, including compensating members who provided a greater initial investment during the startup phase or allocating losses to members who need the tax losses the most.
However, special allocations are prohibited when an LLC elects S Corp status. All shareholders must report income and deductions in proportion to their ownership interest. If you need to make disproportionate distributions for any reason, you’ll either have to abandon your S Corp election or find another way to achieve the same result without using special allocations.
This lack of flexibility can disadvantage business owners who need to allocate income and deductions more creatively.
Limitations on Classes of Stock and Shareholders
S Corporations have a one-class-of-stock rule, meaning that all shareholders must have the same rights, privileges, and obligations regarding voting, dividends, losses, and distributions. This makes it difficult for S Corporations to attract new rounds of investment funds because the company cannot customize their stock classes to secure a greater return or more control.
Additionally, S Corporations can only have up to 100 shareholders, and all shareholders must be individuals (no partnerships, LLCs, trusts, etc.). This limits the options for raising capital through outside investors.
An S corporation must work with a bookkeeper or have solid bookkeeping practices. The bookkeeping requirements for an S corporation are more stringent than those of a typical LLC. For example, S Corps must keep detailed records of profits, deductions, and shareholder distributions to track shareholder basis and help determine whether distributions are taxable and whether shareholders can deduct losses. In addition, an S Corp must include a balance sheet with its federal income tax return. Maintaining a balance sheet might be a new requirement for a single-member LLC that requires more work and compliance costs.
When an LLC elects to become an S Corp, it may mean losing the home office deduction unless the business has an “accountable plan.” An accountable plan is a set of rules for reimbursing business-related expenses paid by employees.
Each month, the S Corp shareholder will need to submit an expense report to the business detailing any out-of-pocket business expenses, including home office expenses, business use of a personal vehicle, cell phone, internet, etc. The shareholder also needs to provide receipts or other documentation for those expenses. The business can then reimburse the S Corp shareholder for those expenses.
An accountable plan can be a good strategy for deducting home office expenses without creating taxable income for the shareholder, but it involves additional recordkeeping requirements. Depending on the LLC owner, these additional complexities could sway them to decide that electing S-Corp status just doesn’t make sense for their business.
Electing S Corporation status can also subject the business and its shareholders to additional state income tax requirements. Depending on the state where the business operates, it may be required to pay state-level corporate taxes.
Some states may also require the S Corporation to pay an annual franchise tax to operate there. This can add up to a hefty sum for businesses operating on limited profits, so it’s important to consider this cost when deciding whether or not to elect S Corp status. In cities like New York that levy a significant additional tax solely on S-Corps, the LLC owners in this city may realize that it really does not make sense for them to elect S-Corp status beacause they could owe even more in taxes.
In some cases, the added costs and complexities of converting to an S Corp may not be worth the tax savings. However, it’s crucial to consider all the implications before you make a decision. If you’re considering making an S Corp election and want to know how it will impact your tax liabilities, please reach out! We’re happy to help you run the numbers and make an informed decision that makes the most sense for your business.