An LLC's owners (members) are taxed by the IRS, instead of the LLC being taxed itself. But the LLC members can change how the IRS taxes them and instead opt for S-Corporation taxation status in an attempt to seek lower taxes. This post will explain what the S-Corp election for tax purposes means and how it can impact a small business.
LLC members pay income tax and self-employment tax on any profits from the LLC. But if the LLC makes the S-Corp election, the company can provide non-wage distributions of profits and losses to the members. These non-wage distributions are not subject to the self-employment tax. Additionally, any members who do work on behalf of the company are paid salaries separate from, and in addition to, their non-wage distributions. These salaries are taxed as normal W-2 income (which includes employment taxes paid by the company and the employee). The employment taxes would only apply to these salaries, not the non-wage distributions. This can result in lower tax liabilities in certain circumstances.

For example, if a single-member LLC makes $100,000 profit in a taxable year and does not take the S-Corp election, the member will pay ordinary income tax and self-employment tax on any profit the LLC makes during a taxable year. However, if the LLC takes the S-Corp election, the member will not pay self-employment taxes on the portion of the $100,000 paid to himself/herself/themselves as a non-wage distributions.
This can further reduce taxes owed if there is a multi-member LLC, but not every member does work on behalf of the company--they are just passive owners. These members could potentially save a lot on taxes by having the LLC take the S-Corp election.
However, putting this into practice without falling into the severe audit bin is a bit trickier. LLC members must pay themselves a "reasonable compensation" for services they provide to the company. They cannot just pay themselves non-wage distributions and no salary. Furthermore, the IRS does not have a specific rule determining what counts as reasonable compensation. Instead, they use a few different guideposts to measure whether the compensation is reasonable.
One important data point the IRS will look to in determining whether the compensation is reasonable is the company's gross receipts. This analysis includes considering the following:
Services of shareholder
Services of non-shareholder employees or
Capital and equipment
The IRS is looking at these factors to see how much work the member puts into the company in relation to gross receipts. The more gross receipts that come from the member's services, the more the member has to pay himself/herself/themselves in compensation.
Additionally, the IRS looks to administrative work the member does at the company. Although the member's work might not directly create gross receipts, the work is still tangentially important to the company’s revenue.
Additional factors the IRS uses to determine what is reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
The use of a formula to determine compensation
In going forward with a S-Corp election, it is important to review all the information carefully and create a well reasoned salary. It is a serious decision and should not be made without seeking the advice of legal counsel and an accountant.
The information provided on my blog is not legal advice and should not be relied on as legal advice. Anyone reviewing this post should use it as only a first step in understanding how the S-Corp election works. LLC members should consult with a lawyer before making any decisions.
Helpful Links:
https://www.irs.gov/pub/irs-news/fs-08-25.pdf
https://www.irs.gov/forms-pubs/about-form-2553
https://www.irs.gov/businesses/small-businesses-self-employed/paying-yourself
https://www.irs.gov/publications/p535
https://www.thetaxadviser.com/issues/2011/aug/nitti-aug2011.html#fn_8