Indiana’s Business Flexibility Act which allows the formation of limited liability companies (LLCs) has been a hit with small and large business owners alike. The LLC has the advantages of income “passing through” to individual owners (thus, avoiding a separate business-level tax) like a partnership, but provide liability protection like a corporation.
What many may not be aware of is that an LLC can make an “S-election” to be treated like an “S-corporation” instead of a partnership. While the tax treatment of LLCs taxed as partnerships and LLCs making an S-election are similar, there are some significant differences. In some situations, making an S-election allows members of an LLC to reduce “self-employment tax”, which effectively increases the amount of federal withholdings tax you would pay if you were otherwise an employee who was not also an owner of an LLC. A member in an LLC making an S-election may be able re-characterize some of his or her income as employment income, thus reducing self-employment tax.
While the S-election may provide some tax benefits, it also places restrictions on who may be a member in an LLC, the number of members in an LLC, the different “classes” of members there may be in an LLC, and the amount and proportion of distributions that are made to members. LLCs taxed as partnerships do not have these same restrictions.