LLC Taxed as S Corp Disadvantages

LLC taxed as S corp disadvantages are under threat from three sources. These include creditors, the government, and those who design the benefits.3 min read

S Corporations and Taxes

In recent years, the government has addressed the rules for S corporations by making them more while cleaning up abusive rules. Some of the changes include:

  • A set limit on how much passive income can be received.
  • Tightened the rules for ownership by an ESOP.
  • Simplified some rules and complicated others.

One area that remains problematic for the government is employment tax, which results in lost revenue from S corporations. This means that S corporation owners can set their wages at a low figure and avoid paying Medicare and Fica taxes on their income. Some politicians are referring to S corp status as being that of a "tax shelter."

The Ways and Means Committee is looking at making a change to how taxes are accessed on small, flow-through companies. One of the potential plans is subjecting S corp owners to employment tax on all profits earned.

The thought of this plan is that it would be more equitable due to the distribution of profits and guaranteed payments from a limited liability company (LLC) that is subject to employment tax. If the tax form is ever adopted by Congress, the plan would negatively impact the appeal of forming an S corp.

For a business concerned about liability issues, it is often advised that an LLC not be formed as a C corporation. This is because this business form offers a high level of asset protection. It also means that to address federal income tax issues in many cases, owners will select the status for sole proprietorship or partnership. With a move toward LLC legal status, it may result in a decrease of regular corporations electing S corporation formation.

About Limited Liability Companies

By default, an LLC is a partnership tax entity that can elect to be taxed as an S corporation or a C corporation and be subject to double taxation. A single-member LLC by default is taxed as a sole proprietorship and can elect to be either an S corporation or C corporation tax entity.


Most LLC member earnings are subject to self-employment tax. With an S corporation, after salaries have been paid to shareholders working in the LLC, the remaining earnings can be passed through as distributions of profits. These funds are not subject to self-employment taxes.

Limited liability companies are considered a partnership for tax purposes. In the event 50 percent or more of the LLCs capital and profit interests are either exchanged or sold within a 12-month period, the LLC will terminate. If 35 percent or more of the losses can be allocated to non-managers, the cash method of accounting may no longer be an option.

LLCs treated as a partnership can't do several things. These include:

  • Incentive stock options aren't an option.
  • They can't take part in tax-free organizations.
  • Section 1244 stock can't be issued.

An S corporation can have one shareholder whereas an LLC must have at least two members to be treated as a partnership. Some states don't tax partnerships but do tax limited liability companies.

It should be noted that the statutes for LLCs lack uniformity, which could result in businesses operating in multiple states not receiving the same or consistent treatment.

While single-member LLCs are allowed in all states, the business can't elect partnership classification for federal tax purposes and must file a Schedule C as a sole proprietor.

About S Corporations and Filing Taxes

Shareholders of a corporation must be citizens of the United States or have U.S. residency status. If shares are transferred or sold to a foreign national, S corporation status is terminated and the company is treated as a C corporation. If an S corporation loses its status for any reason, its owners/shareholders must wait a minimum of five years before being eligible to re-elect S corporation status.

Owners who want to take advantage of the limited liability that goes along with a corporation and the "pass-through" tax treatment available with a partnership often choose S corporation status. An S corporation must report its annual income to the IRS each year, filing Form 1120.

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