Limited Liability Companies and S Corporations, two popular structures in the United States for small business, are both LLCs. The decision to choose the right business entity is a critical one for entrepreneurs. This article will discuss the differences between an LLC and an S Corporation: self-employment taxes, distribution of profits, as well as the qualified business income tax deduction.
Small business owners are most likely to choose an LLC as their initial entity. They are easy to maintain, and they have a lot of flexibility when it comes to income tax. We will examine the income taxation for an LLC that is taxed like a partnership. Profits are subject to both self-employment taxes (SE) as well as ordinary income taxes. We need to examine the salaries of W-2 employees in order to better understand SE taxes. These wages are subjected to FICA (social security and Medicare tax). Employees pay a 6.2% tax on their wages up to $160.200. Employers also pay 6.2% of social security tax up to the wage base. This is indexes for inflation each year and increases annually. The employee and the employer both pay Medicare taxes of 1.45%, which are not limited by wage limits. The employer is allowed to deduct FICA taxes, while the employee cannot.
The LLC does not pay a salary to the owner (member) on the form W-2. Instead, the LLC taxes the profits as self-employment. Self-employment tax is the same as FICA, but the owner has to pay both the employer and employee portions of the tax on their return. The social security tax equals 6.2 + 6.2 = 12.4%, and the Medicare tax equals 1.45+1.45= 2.9%. In addition, SE taxes are 12.4 + 2 = 15.3%. In 2023, the Medicare tax will be assessed on all income, while the social security tax will only be assessed on the first 160 200 dollars. This tax is in additional to ordinary income taxes. If a taxpayer has an LLC profit of $130,000 and files as a single person, they will pay ordinary income taxes in the 24% bracket. They will also pay self-employment taxes of 15.3%. It may be best to continue filing using this strategy at this level of income. This is also a good time to talk about the option of having your LLC taxed like an S corporation.
Self-employment tax is not applicable to profits from an S corporation. It’s not just better to tax as an S Corporation for income taxes. An S Corporation is similar to an LLC in that it does not pay income tax at the entity-level. Instead, the income passes through the entity and onto the individual owners on their income tax returns. The key difference between an S corporation and a LLC is that the shareholders who perform services for the company must be paid “reasonable wages”. As per the above, this reasonable wage is subjected to FICA taxes. However, only the salary portion of it is. The remainder of the profits is subject to ordinary income tax (not SE tax), and the remaining profit can be distributed to the owner from the company without any tax implications. In normal circumstances, this is what happens when you distribute profits and not loan proceeds or funds received for other reasons than profit. You can save on SE taxes as long as you pay an appropriate wage. The transition from an LLC into an S Corporation works best when you reach $100,000 in profit and the profits are growing. Tax savings opportunities increase as profits rise in this range. It doesn’t necessarily mean you should do it without considering other options. S Corporations are not just about tax savings.
In an S corporation, profits and losses are allocated pro-rata to owners (instead of property distributions). This is a major difference to LLCs, which allow for a great deal of flexibility in allocating income and loss according to an operating agreement. This concept also applies in situations where different owners provide different levels of services and property.
A S corporation is limited to 100 shareholders and one type of stock. You and your spouse can be the only members in an LLC. For income tax purposes, you may treat it as a disregarded organization and include income and expenses with your Form 1040 Individual Income Tax Return. An S corporation requires an annual income tax report. A reasonable salary is required. You will need to open a payroll account to file and pay quarterly payrolls, state unemployment taxes, and a federal unemployment tax form 940 and W-2. The additional costs can reduce the SE tax savings.
S corporations must distribute all property and cash in proportion to the ownership of each shareholder. The LLC can be structured in a flexible way to distribute profits when you have several members who contribute different amounts of cash or services to the business. The partnership agreement can specify that profits are distributed to the LLC member who provides services to the business and not to passive investors. Cash distributions are paid out to shareholders in S corporations based on the percentage of ownership. Imagine, for example, that you have three passive investors who own 50% of your S corporation. They do not provide any services to the business, except for the fact that they have contributed cash and equipment. If a company decides to divide $100,000 of profits among its owners, it will give $50,000 to nonpassive owners and $50,000 to passive owners. Each time a distribution occurs, it must take into account the percentage of ownership. Failure to comply with this requirement could lead to the termination of S corporation. S corporations can save you money on taxes. It depends on the way your business is structured and how you want to distribute profits.
You could lose out on significant tax savings if your annual income exceeds the $100,000 threshold. You should at least not elect to be taxed differently than an LLC or sole owner. Since 2018, I have seen cases where taxpayers are not correctly analyzing qualified business income deduction according to IRS code section 19A. If you are filing as a single taxpayer, you can deduct up to $182,100. For married filers filing jointly you can deduct up to $364,200. However, if your qualified business income is more than that, you cannot. This deduction is equal to 20% of your business profits. This deduction is $80,000 for a $400,000 profit business. This deduction is subject to many restrictions and planning. If your business did not pay at least $40,000 in wages, for example, then you may not be eligible. Last month, I met someone who was in the same situation. He paid an additional $20,000 in tax because he didn’t have S corporation status. He can change the setup in 2023. I hope he schedules an appointment with me to discuss it.
Each business will make its own decision about whether or not it wants to be taxed under an S corporation or LLC. Self-employment tax is usually a big part of the discussion, but there are other factors to consider such as distributing profit and optimizing Code Section 199A. For definitive information, it is best to consult your tax advisor.
Donovan Thiessen, CPA, is the owner and founder of The Accountant, LLC. We aim to provide timely and accurate financial analysis and tax advice in order to help business owners take better decisions. You may reach Donovan at [email protected],www.theaccountant.cpa, and 702.389.2727.
Vegas Legal Magazine published the first article Understanding LLCs and S Corps .