What is an LLC?
An LLC or Limited Liability Company is a business entity that is legally separate from its owners, which can be one or many members. As a separate entity an LLC has its own Tax Identification Number. It can even have a bank account and do business under its own name. On the other hand, an S-Corp is not a type of business entity. Instead it is a designation which refers to the S Subchapter of the Internal Revenue Code, which address the tax treatment of corporations and their shareholder.
Single Member LLCs
Single member LLCs are automatically taxed as sole proprietors, which means that the LLC member reports the business income and expenses on their tax return and pays personal income tax on the business profits. Multi-member LLCs are taxed as partnerships, which means in most cases the profits and losses of the LLC are proportionately divided based on each member’s percentage of interest in the business. Multi-member LLCs do not have to proportionately split the profits and losses based on their member’s percentage of interest; this is just the most common way of doing it. Regardless of how the profit and losses are distributed, the entire distributive share is taxed. If the LLC does not distribute the entire share of profits, the members still must pay taxes on the full amount. The net profits/distributive shares of the LLC member or members who work for the business subject to self-employment tax, which is 15.3%. Self-employment tax is social security and Medicare tax (FICA) paid by a self-employed individual. The social security and Medicare tax is normally split by an employer and an employee, but in the case of a self-employed individual, one must pay the full amount. If their share of earnings is over $128,400, then the excess amounts are taxed an additional 2.9%. High income individuals may also be subject to the Additional Medicare Tax of 0.9% on a portion of their earnings.
LLCs Electing S Corp Tax Status:
Single or multi-member LLCs can make the election to be treated as a S Corporation for tax purposes. Normal distributions are not taxable to the members, unless the distribution exceeds the members stock basis. The portion that exceeds the tax basis is taxed at capital gains rates. Also, no distributions from an S-Corps to its shareholders are not subject to FICA taxes. So, for LLC members who do not actively work in the business, they only pay taxes on their share of business profits. For those members who are actively working in the business, they are required to pay themselves a “market rate salary” for the jobs they do. The salary is considered a business expense which reduces profits that pass through to the shareholders, but the salary is subject to FICA taxes. However, unlike single and multi-member LLCs FICA taxes will only be paid on the shareholders salaries, not on all the profits. This allows the member or members to divide up businesses earning into both salary and profits and pay less in FICA taxes by doing so.
There are some businesses that the IRS will not permit to be taxed as an S-Corp. Businesses that cannot make the S-Corp election are foreign LLCs, businesses owned by a nonresident alien, and businesses arranged so that the owner is a corporation or partnership.
Will The S-Corp Election Save You Money?
Though it may seem that pretty straight forward, it is not guaranteed that making the S-Corp election will save you money in taxes. You must first consider what is a reasonable salary for a person who does what you do for your business. It is important to note that the IRS pays close attention to how much an owner’s salary is, so the amount you pay yourself is a significant decision. Then you must consider whether if you are paid that salary would there be any profits left over. If there will be no profits left over, then the S-Corp election may not be good for you. On the other hand, if your business profits are greater than your reasonable salary, then the S-Corp election may be good for you.
If you have an LLC and you want to make the S-Corp election, generally you can do this at any time during the tax year prior to the year that you want the election to go into effect. New businesses on the other hand have about 75 days to make the election.
In addition to the tax consequences of an LLC vs an S-Corp, there are general business pros and cons for each situation. These will not be discussed here, but it is important to mention that there are other things to consider when deciding to make the S-Corp election or not. Before you decide on an LLC vs S-Corp make sure you consult with a business lawyer and an accountant.
Things to Consider
A small home-based business or micro business that lets say is earning $10,000 of profit per year, may lean towards not making the S Corp election. Once the election is made to be treated as an S Corp, there are requirements associated such as the cost of filing an extra tax return for the S Corp and payroll taxes. The cost of filing the extra tax return and paying payroll taxes could be more significant than the tax savings that were mentioned earlier (i.e. avoiding self-employment tax).
On the other hand, for sole proprietors making $30,000 to $50,000 there is a better opportunity to benefit from making the S Corp election. The amount that one can save due to the difference of what would otherwise be self-employment tax and the costs that arise from making the S Corp election (i.e. extra tax return cost, payroll taxes, unemployment taxes), could be significant enough at this point of income for the taxpayer. The below example is not exactly how things would work as I am using a very simplified method in order to make things less complicated, while still showing how this would work.
As a Sole Proprietor:
Self-employment tax @ 15%: $7,500
Income tax federal [$50,000 – $12,000 (standard deduction) = $38,000] @ 12%: $4,560
Total tax ($7,500 + $4,560): $12,060
As an S corporation:
Owner’s wage: $20,000
Self-employment tax (wages @ 15%): $3,000
Income tax $50,000 (profit plus wages) @ 12%: $6,000
Total tax ($3,000 + $6,000): $9,000
**Payroll tax and unemployment tax is not included, Deductible portion of self-employment tax on wages not included**
Obviously, as profits from business continue to rise the opportunity to save by making the S Corp election rises as well. At some point the amount that one could save could become so significant that not making the S Corp election would be like setting money on fire.
How these ideas all come together is different for each business based on its unique factors. Your Molen & Associates tax professional can assist with how all the numbers work to help you make an informed decision.
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