Many individuals embarking on starting their own businesses have a preconceived idea that they want to form a limited liability company (LLC ) instead of an S-Corporation. Often, and I am not making this up, their opinions arise from conversations with barbers! (Nothing against barbers, but hopefully they will read this article and at least consider an alternative.)
Without a doubt, both LLCs and Subchapter S-Corporations are the two primary entities in which owners conduct small business. Both are pass-through entities for income tax purposes, and both provide for limitation of liability (unless the owners treat the entity as their “alter ego”). But an S-Corporation affords more certain treatment of avoiding employment taxes on profits in excess of necessary and reasonable compensation to the owners themselves.
As of the date of this article (initially published March 2010), the combined employer and employee federal employment tax rate is equal to 15.3 percent of compensation paid to an employee.
S-Corporation shareholders who are also employees must pay themselves a reasonable compensation, at least to the extent there are earnings and profits. That owner compensation, like any other employee’s compensation, will be subject to employment taxes the same as all other employees. The amount in excess of a reasonable compensation will be considered as an S-distribution, and will not be subject to employment taxes, essentially putting another 15.3 percent of S-distributions in the shareholder’s pocket.
By contrast, the compensation, as well as the earnings and profits, of an LLC owner are wholly subject to self employment tax (SE Tax) unless the member (owner) does not materially participate in the company. Thus, the amount which could be categorized as the “profit” is still taxed as though it was wages.
Assume that an owner’s compensation is $30,000 for the year. Also assume that the enterprise is neither a passive activity nor rental activity, and that the owner’s other income and deductions net out to zero. A comparison of the employment and income tax effect between an owner, a single person, electing to be organized as an LLC and as an S-Corporation and having earnings and profits, before deduction of compensation ($30,000) in one instance, $50,000, and in the other instance, $150,000, is as follows:
| $50,000 Earnings and Profits |
$50,000 Earnings and Profits |
$150,000 Earnings and Profits |
$150,000 Earnings and Profits |
|
| Taxes | LLC | S-Corp | LLC | S-Corp |
| Employment Tax | $7,065 | $4,590 | $17,260 | $4,590 |
| Income Tax | $7,806 | $8,694 | $33,304 | $35,720 |
| Total Tax | $14,871 | $13,284 | $50,524 | $40,310 |
| Additional Tax Paid as an LLC |
$1,587 | $10,254 | ||
| Percentage of Additional Tax Paid as an LLC | 11.95% | 25.43% |
Clearly, at the earning and profit levels indicated, the benefits of electing S-Corporation status make sense financially, and the greater the amounts available for distribution in excess of compensation, the greater and more dramatic the benefit to be taxed as an S-Corporation and not as an LLC.
A word of caution: Not all entities are eligible to be S-Corporations, as there are restrictions on the number of shareholders, the requirement that they all be natural persons, and restrictions on nationalities of shareholders.