What are the Tax Differences Between an S Corporation and an LLC?
Many small businesses seem to be structured as an LLC or an S Corporation. CPA Gail Rosen was asked, "What is the difference on how these two types of entities are taxed?" Here are her responses to some frequently asked questions about taxes for these two popular business entities.
How are an LLC and an S Corp Taxed?
An LLC's tax is paid on the owner's individual tax return based on percentage of ownership in the company. If you are a 50% owner of an LLC, with $120,000 of net profit, you pay tax on 50% of that net profit($60,000) on your personal tax return.
An S Corporation pays a reasonable salary to the working owner of a business. Then any remaining profit or loss (after subtracting the salary to the owner as a deductible expense) flows through to the owner's personal tax return.
Say you are a working 50% owner of a profitable business and you are paid $50,000 in salary. The corporation has $20,000 of net profit of which you are entitled to 50%; therefore, on your personal tax return, you would pay tax on the salary of $50,000 plus $10,000 profit which equals $60,000 in total taxable business income.
What's the difference in how much it costs to maintain an entity as an LLC versus as an S Corporation?
Any salary that the S Corporation pays to an owner is subject to state unemployment and disability tax. An individual owner of an LLC does not pay state unemployment or disability taxes and therefore saves the costs of paying these payroll taxes. That also means that because an LLC does not pay into these funds, the owner(s) are not entitled to state unemployment or disability benefits.
Many states also charge a minimum corporate tax that can be more costly than the fees associated with having an LLC. These taxes vary by state so you should do some research or consult a CPA in your area.
In the past, S corporation owners were able to avoid paying social security and medicare tax on any profits they made from their business after taking a reasonable salary. Starting in 2011, new legislation has taken away this benefit for many small professional service corporations.
It sounds like an S Corporation is more costly. Is there any reason that I should consider being an S Corporation?
Many new businesses today are freelance consultants who are working as independent contractors for mainly one client. This arrangement has many risks since the IRS can look at the relationship and determine that the consultant should have been hired as an employee versus an independent contractor. However, if the consultant structures the business as an S Corporation, the IRS does not have an issue with the relationship since the owner is structured under a corporate entity and is paying unemployment and disability tax.
As I stated above, an LLC pays tax on the net profit by making quarterly estimated payments to the IRS.
I have some clients who are not diligent about paying their quarterly estimates and therefore get into trouble with the IRS. These people are better off structuring themselves as a corporation and using a payroll service so that their taxes are automatically taken out of their pay.
A lawyer should always be consulted about the limited liability protection an LLC gives versus a corporation. I have always believed that all businesses should pay for good liability insurance for the ultimate protection.
Any other advice to make this complicated decision a little easier for new business owners?
I generally have advised most of my new business clients to start with an LLC entity. The tax law allows you to switch tax-free to an S Corporation once you are an LLC. But, you can not do the reverse. Once you are an S Corporation, you can not switch to an LLC.
There are always other tax, legal and financial considerations that should be taken into account when making such an important decision. Use the services of a good CPA to discuss your specific situation.
How Do LLC vs S Corp taxes affect a one-person business?
In addition to what Gail Rosen has discussed above, I get questions from many business owners who are considering an LLC vs. an S Corp. To a one-person business, there is little benefit to forming an S Corp to retain profits and avoid taxes. If the business has income from the sale of products, it might make sense, but if all the income is generated by the work of the individual, there is little tax benefit.
Here's an example:
Faye has a consulting business; all of her income comes from her work. If she owns an LLC, all of the profits of the business are taxable to her as the owner. If she owns an S Corp, she becomes an employee, and her salary becomes an expense. But she must pay herself a reasonable salary, as noted above. A reasonable salary is probably all of her income, so she is still probably going to pay business tax on almost all of her net income.
Disclaimer: The information in this site is for general purposes, to help you understand the basics. It's not intended to be tax or legal advice. Consult your CPA or attorney to discuss your specific business questions.