LLCs are the most popular legal structure for businesses. They’re flexible, provide significant legal protection to the LLC members, and have less maintenance requirements than corporations. A separate, but related issue is how an LLC should be taxed. A growing number of LLCs are electing to be taxed as an S corporation. The main benefit is to reduce employment taxes. For many types of businesses, “all” of the owner’s income is subject to the 15.3% self-employment tax. In electing to be taxed as an S corporation, the LLC members pay themselves a reasonable salary (that’s subject to employment tax) and the remaining amount of money they take out of the LLC avoids that tax.
Becoming taxed as an S corporation occurs by filing a fairly simple election. However, what virtually all business owners forget about is the importance of updating their LLC operating agreement. Many operating agreements allow LLC members to transfer their interests to certain persons or entities “without” the approval of the other members. S corporations have very strict rules about who can be an owner. If the operating agreement “does not” have certain protections, a disgruntled LLC member could gain an incredible amount of negotiating leverage on the other members by threatening to transfer the LLC interest to an “ineligible” owner and in doing so, terminate the S election. This event would be financially devastating and create two levels of federal and state taxes for the LLC members.
Avoid this risk by having your operating agreement updated to reflect these tax changes. Then you can protect your LLC while achieving significant tax benefits. If you have any questions or would like assistance with this process, feel free to contact our office.