Should You Form an S-Corp? Pt. 2
Part 2 – Business Entity Comparison: S Corp Status vs LLC
Entrepreneurs face several choices when structuring their business. This series of posts is intended to help them evaluate whether or not they should utilize S Corp status. The last post covered what an S Corp actually is (a tax status, not a business entity) and reviewed the benefits of an S Corp over a C Corp (pass-through taxation and the QBI deduction). This second post will compare the benefits of an S Corp over an LLC.
Importantly, and as explained in the last post, because an S Corp isn’t itself an entity, the company must first be formed as a C Corp or an LLC. As a result, when evaluating the benefits, you should compare the advantages of S Corp status against the traits of the entity that was initially formed.
Benefit of S Corp Status vs an LLC
1) Self-employment tax savings.
The primary benefit of an LLC electing S Corp status is the tax savings that active members will receive from a reduction in their Self-Employment Tax. To understand the tax savings here, it’s easiest to split a business owner’s taxable income into two components: salary and profits.
Although an LLC technically cannot pay a traditional salary to its members, it can make guaranteed payments to them, which is the functional equivalent. With guaranteed payments, a payment is made to the recipient regardless of whether the LLC makes a profit. Similar to a salary, guaranteed payments are treated as an expense of the LLC that passes through to the members as a deduction. Also similar to a salary, guaranteed payments are considered “compensation.”
All income is subject to ordinary income taxes, but “compensation” faces an extra tax. The IRS taxes compensation at a rate of approximately 15.3% to fund Social Security and Medicare. For salaries, the tax is called payroll tax or FICA tax (from the Federal Insurance Contributions Act under which the tax arises); for guaranteed payments, the tax is called the Self-Employment Tax. Thus, regardless of the name, the salary portion of an owner’s income is generally considered “compensation” and subject to the tax.
The tax savings comes from how the remaining portion of an owner’s business income is treated. In an LLC, profits and guaranteed payments are both considered compensation. As a result, each active members’ distributive share of profits is subject to the Self-Employment Tax, and this is regardless of whether a distribution was made.
That scheme is different for an S Corp. Profits from an S Corp are generally not considered compensation and, therefore, not subject to payroll taxes. Owners of an S Corp can still receive the profits through a dividend, just as an LLC owner could receive the profits through a distribution. But the dividend of an S Corp owner would be free of the extra tax. As a result of this difference, LLC owners who elect S Corp status can realize significant tax savings.
There is, however, an important caveat. Active owners of an S Corp cannot designate all of their business income as “profit” to be received by dividend. The company must pay a “reasonable” salary to its employees. Although the standard for a “reasonable” salary is open to some debate, S Corp owners should plan to designate as their salary the same amount that they would expect to get paid if they did the same job for a third party. Oftentimes, owners will use a 60/40 salary/dividend split. If an S Corp fails to pay a reasonable salary, the IRS may reclassify the income as salary and assess the tax.
It’s also important to remember that this benefit is limited for higher-earning S Corp owners. As mentioned above, the Self-Employment Tax is comprised of taxes for Social Security and Medicare. Social Security is a 12.4% tax and Medicare is a 2.9% tax. Although the Social Security tax is higher, there is a limit on the amount the government can collect for Social Security each year. As of 2020, only a person's first $137,700 of compensation is subject to the Social Security portion of the Self-Employment Tax. Income above this threshold is still subject to the Medicare tax. What this means is that if the “reasonable” salary you expect to take as an S Corp employee is near, or in excess of that threshold, the S Corp designation will not offer the same tax savings.
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In certain situations, an S Corp can provide significant tax savings over a traditional LLC. However, discussing the myriad advantages and disadvantages at the theoretical level only goes so far. Determining the best choice for a particular business requires an examination of its unique circumstances.
If you are trying to decide between various business forms, want to form an S Corp, or have any questions about business entities, don’t hesitate give us a call, or reach out to email@example.com.
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