Should I Start and S-Corp or an LLC?

A common question of entrepreneurs is “which legal entity should I create to operate my business?” This question has many ramifications including legal and tax implications. Entrepreneurs should discuss this issue with a qualified attorney and CPA before making the final decision. This article provides some general guidance on the tax ramifications of both entities…

At the outset, it’s important to understand that an LLC is an entity created under the laws of your state. LLC’s can actually be taxed several different ways. By default, an LLC with just one owner is taxed as a “disregarded entity”. That’s a fancy way of saying that the income from that LLC flows onto the owners tax return (normally schedule C) without the requirement of filing a separate tax return. From a tax standpoint, there would be no difference running your business as a disregarded, single-member LLC and a sole-proprietorship.

If an LLC has two or more members, by default, it is taxed as a partnership. The income generated by a partnership flows through the partnership and is taxed on your personal return, at your personal tax bracket. For example, Mary and Joe create an LLC and agree to divide income and expenses equally. During the year, the LLC has $300,000 of business income and $100,000 of business expenses. 50% of the net income of the LLC ($100,000) is taxed on Mary’s return at her marginal tax bracket and 50% of the net income is taxed on Joe’s return. A partnership return is filed to show, among other things, how much income should be reported by each partner.

Here is where this issue can be confusing: An LLC can elect to be taxed as an S-Corporation. So, if you would like to be taxed as an S-Corporation, you can (1) form a corporation and elect to be taxed as an S-Corp or (2) form an LLC (or other qualifying entity) and elect to be taxed as an S-Corporation. With that in mind, the rest of this article discusses some differences between LLC’s (taxed as partnerships) and S-Corps.

An S-Corp is taxed similarly to an LLC (taxed as a partnership), with the income flowing through to the shareholders but there are also some key differences. One main difference is that an S-Corp provides an opportunity to save on self-employment tax, whereas LLC’s (taxed as partnerships) generally do not. Self-employment tax is a term to describe the burden of social security and Medicare tax borne by the self-employed. In 2014, this rate is 15.3% of the first 117,000 of wages. In the example above, if the LLC income is Mary and Joe’s only income, they would not only have to pay income taxes on the money, they would also each owe 15.3% or $15,300 in self-employment tax.

Here is where a key difference between LLC’s (taxed as partnerships) and S-Corps comes into play. The profits of an S-Corp are not subject to self-employment taxes whereas the profits of the LLC are. The catch is that S-Corp shareholders, who performs services for the S-Corp, need to pay themselves a reasonable salary. Whether or not a salary is considered reasonable depends on the facts and circumstances (the details of which go beyond the scope of this article). Let’s suppose that a reasonable salary for Mary and Joe is $70,000 each. If John and Mary were to be taxed as an S-Corp, Social security and Medicare tax would apply to their $70,000 salaries but it would not apply to the $30,000 of profit that they each claim. This would save each of them $4590 in taxes ($30,000 * 15.3%).

There are some downsides of S-Corps. S-Corp owners are required to pay themselves a reasonable salary, which means that quarterly payroll taxes and W-2’s need to be filed. Federal unemployment tax (FUTA) will also apply to their wages. S-Corp owners also run the risk of having their salary disputed by the IRS if the IRS believes it is unreasonably low. Finally, S-Corps are much stricter in the way they allow distributions to be taken. All distributions must be given according to shareholder percentage. LLC’s (which are taxed as partnerships) generally have more flexibility.

In short, business owners must look carefully at tax and legal ramifications of a particular entity. LLC’s can be taxed as sole-proprietorships (when there is just one owner), partnerships, or S-Corps. Make the decision after carefully consulting with a qualified professional.

If you would like assistance in evaluating the tax consequences of a particular entity, give PorterKinney a call at 509-713-7300.

Disclaimer: While PorterKinney PC has made every attempt to ensure the accuracy of this document, it is not responsible for any errors or omissions, or for the results obtained from the use of the information in this presentation. This document been prepared for information purposes and general guidance only and does not constitute legal, accounting or other professional advice. Circular 230 Notice: The information included in this presentation is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties or (2) promoting, marketing, or recommending to another party any tax related matters.