Should I elect S Corporation status, or elect as an LLC to be taxed as an S Corporation?
I own my small business. As a CPA, one of the most confusing things clients who start their own business encounter are the laws concerning owner’s compensation as it applies to forming an LLC or an S Corporation.
When someone forms a single LLC, the IRS defaults that entity as being a “sole-proprietorship.” As a sole-proprietor, if the owner renders services, he/she does not qualify for regular W-2 payroll. Any money distributed is referred to as an owner’s draw. All profits are subject to self-employment tax, whether the owner leaves the funds in the company or not. Rental and passive businesses aside, in most organizations where the owner is active in the business, all profits are subject to self-employment tax. The tax rate on self employment income is 15.3% up to $117,000 and 2.9% after that (there is another .9% as you reach either 200K and 250K.)
This is not true with an S Corporation. In an S Corporation, the owner can determine how much salary he or she wants to take. Registering as an S Corporation obviously offers some payroll advantages, but the IRS is wise to this. When the IRS accepts an application to become an S Corporation, in the acceptance letter there is a statement saying that an S Corporation must pay reasonable compensation subject to employment taxes to shareholder employees in return for the services that the employee provides to the corporation.
In effect, what the IRS is saying is: “Don’t think that because you’re an S Corporation you can take out all of the company’s earnings, call it distributions, and not pay self-employment tax.” The accepted rule of thumb here, as I advise my small-business-owner clients who are S Corporations, is a certain amount of compensation should be classified as payroll, and a certain amount distributed as a return on investment, commonly known as distributions, since the owner is not only an employee but the major investor in the corporation.
In this day and age, the LLC has become the entity du jour, so many of my clients want to be an LLC no matter what it costs them. LLC and S Corporations are legal distinctions, not tax distinctions. Do not despair, there is a way for an LLC to take advantage of the S Corporation compensation rules. It’s fine to be an LLC, but what the business owner can do is elect with the IRS the option of being taxed as an S Corporation even though they are an LLC. Then the S Corporation rules for compensation apply.
- All income from an LLC that has not elected to be taxed as an S Corporation is subject to self-employment tax, whether or not the owner takes any distributions.
- In an S Corporation, or an LLC that has elected to be taxed as an S Corporation, this is not the case. The amount of compensation that’s subject to payroll taxes can be computed by the owner, and his tax advisor, with an eye for what the IRS might consider reasonable.
Any questions concerning this should be directed to your tax advisor. If you don’t have a tax advisor, feel free to call us. We will be happy to answer your questions.