The Problem: A Legitimate Business With a Mismatched Tax Setup
This type of situation comes up more than most business owners realize. Someone starts a service business, uses a legal formation service to create an LLC, and assumes the tax piece is taken care of. It is not, and usually nobody tells them that.
In this scenario, the client had been in business for several years. Revenue was growing. They had a separate business bank account, invoiced clients, and kept reasonable records. On the surface, everything looked fine. But every year, they filed Schedule C and paid self-employment tax on 100 percent of their net profit. The LLC, which could have been structured more efficiently years earlier, was being treated exactly like a sole proprietorship by default.
The problem was not that they had done something wrong. The problem was that nobody had ever explained what the LLC actually does at the federal tax level. In most states, forming an LLC is a state filing. It creates legal liability protection. It does not, by itself, change anything about how the IRS taxes the income.
Per the IRS: A single-member LLC is treated as a disregarded entity for federal income tax purposes unless a separate election is made. Income flows to Schedule C by default. Source: IRS.gov: Single-Member LLCs
What the Review Found
When the client came to LMN Tax, the first step was understanding exactly what the current setup was. That meant reviewing prior returns, the state LLC filing, and any IRS correspondence. No elections had been made. No payroll had ever been set up. The business was profitable and had been growing for three years.
At the income level the business was generating, the self-employment tax overpayment was significant. The IRS currently taxes self-employment income at 15.3 percent up to the Social Security wage base, plus 2.9 percent above that threshold. A business generating meaningful net profit and paying all of it as self-employment income, when an S corp election could have shifted a portion to owner distributions not subject to SE tax, is a real cost.
Self-employment tax rates: Social Security portion (12.4%) applies to net self-employment income up to the annual wage base ($168,600 for 2024). Medicare portion (2.9%) applies to all net self-employment income. Source: IRS.gov: Self-Employment Tax
Evaluating the S Corp Election
An S corp election is not automatically the right answer. Nausheen walked through the actual numbers: what a reasonable salary for the owner's role would look like, what the payroll costs and compliance overhead would be, and what the net savings would be at that income level. The math made sense. But the timing and the process required a clear plan.
A late S corp election is possible in many cases. The IRS allows late elections under Revenue Procedure 2013-30 when the entity can demonstrate that the failure to file timely was due to reasonable cause, and that the entity has been treated as an S corp for all purposes.
Late S corp election relief: IRS Revenue Procedure 2013-30: Provides automatic relief procedures for late S corp elections in certain circumstances.
What the Cleanup Looked Like
The cleanup did not happen overnight. But it had a clear sequence: confirm the current filing history, determine whether amendments to prior returns made sense given the circumstances, file Form 2553 for the S corp election going forward, establish a payroll setup with a reasonable salary, and set up the correct quarterly filing structure.
Going forward, the business had a structure that matched what it actually was. The owner understood what their salary meant, what distributions meant, and what the ongoing compliance looked like. The uncertainty was gone.
- Clear picture of what the LLC's current tax classification was and what that meant
- Honest evaluation of whether an S corp election made financial sense at the current income level
- Path forward for the election, payroll setup, and correct quarterly filings
- Prior years reviewed to determine whether amendments were warranted
- Owner understood the structure and what it required going forward
If Your Situation Looks Like This One
The version of this situation varies. Sometimes the business has been operating for two years, sometimes ten. Sometimes it is a single-member LLC, sometimes there are partners. Sometimes the prior preparer set something up that nobody explained. The common thread is that the legal structure and the tax structure do not match, and nobody has looked at it carefully.
A Business Tax Advisory review is how that gets addressed. Nausheen reviews what you have, explains what it is costing you, and lays out the options clearly. Including an honest answer to whether an S corp makes sense for your situation or not.