Small Business Basics: How S Corps and LLCs Pay Taxes
Which business type is right for you?
Many small businesses are structured as limited liability companies (LLCs) or S corporations. It's generally advisable to start out with an LLC entity, but this rule of thumb might not suit everyone. Tax law allows you to switch tax-free to an S corporation if you're already an LLC, but you can't do the reverse—you can't switch to an LLC when you're an S corporation.
CPA Gail Rosen explains the differences between these two types of business entities and how they're taxed.
An LLC vs. an S Corp
An LLC's tax is calculated and paid on the owner's individual tax return based on his percentage of ownership in the company. If you're a 50 percent owner in an LLC that has $120,000 in net profit, you'd personally pay tax on 50 percent of that profit, or $60,000.
An S corporation pays a reasonable salary to the working owner of the business, then any remaining profit or loss flows through to the owner's personal tax return after subtracting that salary as a deductible expense.
Let's say that you're a working 50 percent owner of an S corp. You're paid $50,000 in salary. The corporation has $20,000 of net profit to which you're entitled to 50 percent. You would pay tax on your salary of $50,000, plus $10,000 of profit, or $60,000 in total taxable business income. You would claim this income on your personal tax return.
What's the Difference in Cost?
An S corporation generally pays more tax than an LLC because of additional payroll taxes and state corporate taxes that can be applicable. Any salary the S Corporation pays to an owner is subject to state unemployment tax, disability tax, Social Security tax, and Medicare, at least a portion of which is payable by the corporation.
S corporation owners used to be able to avoid paying Social Security and Medicare tax on any profits they made from their businesses after taking reasonable salaries, but legislation took this benefit away beginning in 2011 for many small professional service corporations.
An individual owner of an LLC doesn't pay these taxes, so the business saves this cost. But the owners aren't entitled to state unemployment or disability benefits because an LLC doesn't pay into these funds.
Many states charge a minimum corporate tax that can be costlier than the fees associated with having an LLC. These taxes can vary, so consult with a CPA in your area to find out what they are in your location.
Are There Any Advantages in Forming an S Corporation?
Many new businesses are freelance consultants who work as independent contractors for mainly one client. This arrangement carries some risk because the IRS can look at the relationship and determine that the consultant should have been hired as an employee, not as an independent contractor.
But the IRS generally doesn't have an issue with the relationship if the consultant structures his business as an S Corporation. The owner is structured under a corporate entity and is paying unemployment and disability tax.
An LLC pays tax on its net profit by making quarterly estimated payments to the IRS. Some owners aren't diligent about paying their quarterly estimates and they end up getting into trouble with the IRS. These people might be better off structuring themselves as corporations as well, and using a payroll service so their taxes are automatically taken out of their pay.
A lawyer should always be consulted about the limited liability protection an LLC gives versus that of a corporation. All businesses should consider paying for good liability insurance for ultimate protection.
The information contained here is for general purposes to help you understand the basics. It's not intended as tax or legal advice. Always consult your own CPA or attorney to discuss your specific business questions.