S Corp vs. LLC
S Corp vs. LLC
If you are the only owner of your business, you may have decided to structure it as a limited liability company, or LLC, to protect your personal assets. But you may have heard that, for tax purposes, you should be an “S corporation." The reason? Income generated by an LLC is all taxable as personal income—while you can deduct business expenses from an S corp's taxable income. But the truth is, you can form a single-member LLC and still take advantage of S corp. taxation if you choose to do so.
This article will explain the differences between the two business classifications, and show you how you how to form a single-member LLC while taking advantage of S corp. taxation.
S Corp. versus LLC
What is an LLC?
The exact LLC definition varies slightly from state to state but, basically, an LLC is a business entity that is legally separate from its owners, who are known as “members." An LLC can have one member or many members.
Small business owners often choose to form an LLC instead of a corporation because LLCs offer more flexibility in the way they are managed and usually have fewer recordkeeping and reporting obligations than corporations.
What is an S corporation?
Unlike an LLC or a C corporation, an S corporation is not a type of business entity. The S corp. designation refers to the way a business has chosen to be taxed under the Internal Revenue Code.
S Corp. vs. LLC: Tax Benefits
For tax purposes, the IRS classifies businesses as sole proprietorships, partnerships, C corporations, or S corporations. There is no "LLC" tax classification and, therefore, LLCs are taxed as though they are another type of business.
The IRS automatically taxes single-member LLCs as sole proprietorships and multi-member LLCs as partnerships. But an LLC can also choose to be taxed as a C corporation or as an S corporation.
What's the difference between sole proprietorship LLC taxes and LLC taxed as S corp. taxes? For many small businesses, the main difference is in the way business owners pay Medicare and Social Security taxes—also known as "self employment taxes." Some LLC owners can save money on these taxes by choosing S corp. taxation.
If a Single-Member LLC Is Taxed as a Sole Proprietorship
The LLC member reports business income and expenses on his or her personal income tax return and pays personal income tax on company profits. The member is considered self-employed and thus is responsible for paying Social Security and Medicare taxes on those profits.
(As of 2016, self-employed individuals pay a 12.4 percent Social Security tax on the first $118,500 of income, and a 2.9 percent Medicare tax on all income, with an additional 0.9 percent Medicare tax imposed on high earners. Employees are subject to these same taxes, but the employer pays half and the employee pays half.)
If a Single-Member LLC Is Taxed as an S Corporation
The member can be considered an employee of the business. An owner-employee must be paid a reasonable salary. The LLC will report the salary as a business expense, and the owner will report both the salary and any remaining business profit on his or her personal tax return.
However, unlike the sole proprietor LLC owner who must pay Medicare and Social Security taxes on all profits, the S corporation and its owner will only pay these taxes on the owner's salary. The remaining profits are not subject to these taxes.
Here's One Example
Suppose you are an LLC owner taxed as a sole proprietor and your business makes $100,00 profit. You will report $100,000 of income, and you will pay Social Security tax and Medicare tax on the entire $100,000.
Now suppose you have elected to be taxed as an S corp. and have determined that your reasonable salary is $50,000. Your salary is a business expense, so the business now has a $50,000 profit. You will still report $100,000 of income [$50,000 of salary plus $50,000 of profit], but you and your business will only pay Social Security and Medicare taxes on your $50,000 salary.
S Corp. or LLC—Which Is Right for You?
The IRS's S corporation definition makes it clear that not every business qualifies to be taxed as an S corp. Most single-member LLCs will qualify, but you can't choose S corp. taxes if any of these apply to your single-member LLC:
- It is a foreign LLC
- The owner is a nonresident alien
- It is structured so that the owner is actually a corporation or partnership
(Multi-member LLCs that have more than 100 members also cannot be taxed as S corporations.)
To evaluate the benefits of S corp. vs. LLC taxation, you must consider whether changing to S corp. tax status will save you money. Find out what a reasonable salary would be for a person who does what you do. The IRS scrutinizes owner-shareholder salaries, so it is important not to set an artificially low salary for yourself. Then ask, if you paid yourself that salary, would your business have any profit left over? If the answer is no, then S corp. taxation may not help you.
If your business profits are greater than your reasonable salary, S corp. taxation may save you money. Consider also that your tax return will be somewhat more complex and, if you don't have other employees, you will have to set up tax withholding. An accountant can advise you on other benefits and consequences of choosing LLC vs. S corp. taxation for your business.
So, LLC or S Corp?
If you've already formed your LLC but are unhappy with the tax consequences headed your way, you can change your tax status. In general, you can elect LLC S corp. status at any time during the tax year prior to the year you want the election to take effect, or during the first two and a half months of the current year. New businesses have approximately 75 days to elect a different tax status.
Before deciding on S corporation vs. LLC taxation, be sure you carefully evaluate the various pros and cons and seek advice from a business lawyer or accountant.
Legalzoom can help you start a business. Whether you decide to start an LLC or start an S corp, the process is simple and affordable. If you're not sure which business structure is right for you, our legal plan attorney can answer your questions about LLCs and S corps and help you decide.