What is an S Corp?
First, for purposes of this blog, I am going to keep “S Corp” contained to the relevance of an LLC and not delve into C Corporation, which is generally what you think of when you think of big corporations.
LLC v. S Corp
Many folks ask, what is the difference between an S Corp v. LLC?
Well, that’s not an entirely correct question to ask. An S Corp is simply a tax election that LLCs may make. It comes from the IRS Tax Code “Subchapter S.” The election doesn’t affect your business formation – you can still remain an LLC. The “S Corp” is solely related to your tax status and how you chose to file.
Rewind for a sec. . . as a single (or multi member) LLC, can chose to be taxed as a sole proprietor (partnership if there is more than one of you) or an S Corp. You still get the liability protection because you’re an LLC, but the tax treatment differs.
LLC Taxed as Sole Proprietorship (or Partnership)
If you chose to be taxed as a sole proprietor (or partnership), you will report your profit or loss on your personal tax return. That’s why we call these entities “pass through” entities because basically, the tax liability gets passed through to the LLC member or members. If you are a single member LLC, you will file a Schedule C to your personal tax return; if you’re a multi member, you’ll attach a K-1.
Your entire net profit, that’s after your deductions and write offs, will be subject to Self-Employment (SE) taxes, which are Medicare and Social Security. These are the taxes that you used to pay when you were employed by an employer. Only your employer would pay half, and you would pay half. Now, as your own boss, you get to pay those FICA taxes yourself. It doesn’t end there, because after you pay the SE tax, you still have to pay your state and federal income tax just as you would on your personal income tax. (Plus, your in at higher risk for an IRS Audit!)
So say you make 100k, you would not only be responsible for the $15,300 in self-employment taxes, but also state and federal income taxes on your net profit. That could amount to a gigantic amount of taxes.
S Corp Advantages
Let’s compare this to an S Corp. Once you elect S Corp status, you will be required to take a reasonable salary. The key is reasonable. The IRS doesn’t give definitive guidelines on this but – basically answer me this: What would you pay someone in your seat to do your job? This is the first part of your income. Then, you can take distributions from the remaining profits. Here’s where the magic of the S Corp comes in. You are still required to pay the SE tax on your salary, but not the distributions. This is why taking a reasonable salary in the IRS’s eyes is so vital, because why wouldn’t you just take distributions all the time? With the remaining distributions, you will pay your state and federal taxes.
Using the same round number of 100k above, say your reasonable salary is 70k and distributions of 30k. You will pay 15.3% SE tax on the 70k, or $10,710 (much less than $15,300), plus the federal and state income tax.
I mean, there’s a lot I could do with $4,590!
Disadvantages of S Corp
So why doesn’t everyone do this? Well, there are costs associated with establishing and continuing the S Corp. Generally, you will want to elect for S Corp status when you start to generate some sort of profit, because you do have to establish a payroll system, file a separate tax return and bear other associated costs.
Also, if the LLC purpose is passive income, such as rental income, then you don’t have to pay the self-employment taxes anyway.
There are also certain IRS requirements to be eligible to be treated as an S Corp, like the business must be domestic, have less than 100 shareholders, must be US citizens or residents and more.
Putting it all together, S Corps can be an awesome tax saving tool, under the right circumstances. If it’s something you are considering, I’d advise a chat with your trusted lawyer, accountant or CPA before making the election.