Start an Illinois S Corp

S Corp Illinois: Pros and Cons

While S corporation classification does come with benefits for some businesses, making this election might not be right for every company. Carefully weigh the pros and cons before deciding how you want to move forward. Consult a tax professional about whether the S corporation election would be best for your business.

Advantages of S Corporation Election for LLCs

The advantages of filing as an S corporation for an LLC differ from the advantages for C corporations. Let’s look at the advantages for LLCs first.

By default, a traditional LLC already has pass-through taxation, so the benefits of S corp election for an LLC have to do with self-employment taxes. This takes some explanation, but for certain LLCs, it could save a lot in taxes.

Self-Employment Tax Explained

The members of a standard LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment taxes (Social Security and Medicare, which add up to about 15.3%) on their federal taxable income from the LLC. This is more than the taxes they’d pay for Social Security and Medicare when working for someone else because their employer would pay part of them.

Two Sources of Income

But when the members elect S corp status, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee of the LLC. Once they do that, they only pay Social Security and Medicare taxes on their salary and not the profits they receive. Depending on factors such as how profitable your company is, the savings could add up to a lot. (Of course, the members must still pay illinois income tax, federal income tax, and all other applicable taxes on their share of the profits.) Money paid out as salary is also a tax-deductible expense for the business. 

Reasonable Compensation

One caveat to this arrangement is that the IRS expects you to pay yourself a “reasonable” salary as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $5 and avoid contributing anything to Social Security and Medicare. 

But what is “reasonable compensation” to the IRS? The instructions on Form 1120-S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” While the terms aren’t completely defined, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning for the same work.

If the IRS determines that your salary isn’t reasonable, it has the authority to reclassify your non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases have supported their right to do this.

Disadvantages of S Corp Status for LLCs

Having an LLC with S corp status can also have drawbacks over a traditional LLC:

Stricter Requirements 

As we listed above, S corps have more qualifications to meet than a standard LLC. An S corp can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A traditional LLC doesn’t have these limitations.

More IRS Scrutiny

Because of the above restrictions and the requirements about paying yourself a “reasonable salary,” the IRS tends to monitor LLCs filing as S corps more closely. That could mean a greater chance of being audited, even if you follow the law to the letter.

In fact, S corp owners may want to observe some of the same formalities that C corporations do. LLCs don’t have the same level of financial and professional regulation and don’t have to create corporate bylaws or elect corporate officers, but it might be wise to keep a corporate records book, even if you’re not legally required to do so. It could help you stay prepared in the event of an audit.

Additional Accounting and Bookkeeping

Having an S corporation generally means more paperwork. If you don’t already have to do payroll for your business, being an owner-employee means that you’ll have to start doing so. Your taxes will be more complex, as well.

These added complications could mean that you’ll have higher administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software.

Advantages of S Corp Status for C Corporations

If you have a C corporation (the default form of corporation), filing as an S corp does have its advantages:

Pass-Through Taxation

One big disadvantage for traditional corporations is “double taxation.” When the corporation makes money, the IRS taxes those profits on the corporate level. But when those profits are ‌distributed to the individual owners (shareholders) as dividends, the profits are taxed a second time on the shareholders’ personal tax returns.

But when a C corporation qualifies to be an S corp, those profits are usually only taxed at the individual level, at least for federal income tax. The business itself usually isn’t taxed on them. This is called “pass-through taxation,” and it’s how business entities like sole proprietorships and general partnerships are taxed. LLCs are also taxed this way unless they choose to be taxed as a corporation.

We need to add here that, since the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to a flat 21%. So, the disadvantages of double taxation aren’t as severe now as they once were. 

Writing Off Losses

Just as business profits pass through to the owners of an S corp, so do the losses. Unlike the shareholders of a C corporation, S corporation owners can write off the company’s losses on their personal income statements. 

This can help offset their income from other sources and can be helpful if the corporation loses money in the first couple of years. Still, make sure you’re aware of ​​the IRS’s shareholder loss limitations.

QBI Deduction

Under the previously mentioned Tax Cuts and Jobs Act, some S corp shareholders may be able to deduct up to 20% of their qualified business income (QBI). This deduction isn’t available to C corporation shareholders.

QBI is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.” The IRS website has a detailed explanation as to what is and is not included in QBI. There’s an income threshold that, if exceeded, may reduce your QBI (see the IRS website for more details).  

Disadvantages of S Corp Status for C Corporations

S corporation status also has its downsides over a standard corporation:

Limited Number of Shareholders

As we mentioned, an S corp can’t have too many business owners, no more than 100 shareholders. A C corporation has no such restriction. That limitation could be an issue later if the corporation expands and goes public.

Limited Types of Shareholders

All S corp shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand internationally. You also can’t have partnerships or corporations as shareholders. C corporations don’t have these limitations.

One Class of Stock

Corporations sometimes attract investors by offering preferred stock. That’s fine for C corporations, but the IRS doesn’t allow it for S corps.

More IRS Scrutiny

Because of the extra restrictions, the IRS watches corporations with S corporation election more closely to see if they’re in compliance. In other words, your corporation is more likely to get audited.

We can’t stress enough how important it is to have tax guidance about your specific situation from a qualified tax professional. An accountant with S corp experience should be able to make sure you stay in compliance with the IRS, and they may also be able to help you find additional tax savings you were unaware of.

Illinois-Specific Considerations

In an S corp, the business itself doesn’t usually pay federal income taxes. But what about Illinois taxes?

Under the Illinois Income Tax Act, any corporation that elects S corporation status for federal income tax purposes is automatically an S corporation for the purposes of Illinois income tax. In other words, an S corp has the same pass-through taxation for state income taxes as it does for federal income taxes, at least as long as the federal S corp status remains in effect. Some states require you to make a separate S corporation election for state income tax, but not Illinois.

Illinois S corporations still have a couple of other taxes to be aware of, though.

Personal Property Replacement Tax

Personal property replacement tax, also known as replacement tax, is a tax on the net income of corporations, S corporations, partnerships, and trusts. It was created to compensate for the loss of power local governments had to levy personal property taxes on business.

As of 2023, S corporations pay a 1.5 percent replacement tax on their net Illinois income.

Pass-Through Entity Tax 

Pass-through entity (PTE) tax is an optional tax for S corporations and partnerships that allows them to make a federal deduction of state and local income taxes that are, as of the Tax Cuts and Jobs Act of 2017, limited to $10,000 annually. This $10,000 limit imposed by the Tax Cuts and Jobs Act is known as the “SALT (state and local taxes) Cap.” Illinois is one of several states that have recently enacted legislation related to this cap.

The PTE tax is effective for tax years ending on or after December 31, 2021, and beginning before January 1, 2026. A qualified Illinois tax professional can help you determine whether paying this optional tax and shifting these state and local deductions to the federal level is the best option for you.

We can help

Starting an S corp in Illinois can be complicated, but we’re here to make it as easy for you as possible.

If you want to form an LLC with S corp status, our S corp service can help you do just that. Plus, we offer other services to help you run and expand your business and stay in compliance with Illinois and federal laws.