A limited liability company (“LLC”) with two or more members is taxed as a partnership.
The S corporation, just like the partnership, offers the principal tax advantage of being a conduit for taxable income, rather than a tax-paying entity. Profits and losses of the S corporation are not reported at the entity level; rather, such items flow through to the individual owners, and only a single level of tax is paid at the individual level.
One reason for the LLC to elect as S corporation may be payroll taxes. In general, all of the income that passes through a partnership to a partner (other than a limited partner) is self-employment income subject to payroll taxes.
For an S corporation, however, it may be possible to treat a reasonable amount of earnings as wages subject to payroll taxes, and treat the remainder as pass-through S distributions (or dividends) that are not subject to payroll taxes. As developed in a previous post, the shareholder-employee needs to receive a reasonable salary for his services to the S corp.
An LLC that has elected to be taxable as an S corporation for federal tax purposes is also treated as an S corporation for California tax purposes.
However, members of the LLC need to be very careful as the LLC remains a limited liability company under state law. They need to review and amend the operating agreement of the LLC that contains partnership tax concepts to make sure it meets all the required S corp qualifications including the single class of stock requirement.
For example, they need to avoid special and regulatory allocations of income and loss, silent owners, disparate arrangements for income or losses, default allocations or distributions that may potentially violate the single class of stock rule. Unless these provisions are canceled from the LLC agreement, these provisions are likely to disqualify the LLC from making an S election.
If it does not meet all of the required qualifications, the S election will not be valid and the LLC will be taxed as a C corporation. It will be then subject to tax on earnings at both the corporate level and shareholder level.
I created this blog to help understand certain basic aspects of U.S. tax law. Of course, each situation is unique and nothing that is on this site will ever replace the expert advice of a tax professional.
Please do not hesitate to contact me should you have any question