Are There Tax Advantages to an S Corporation Compared to an LLC?
An S corporation delivers several potential tax advantages as compared to an LLC.
Before we discuss the relative tax advantages of S corporations, however, we should discuss both the mechanics of setting up an S corporation or an LLC as well as the default rules that apply to LLC taxes.
Setting Up an S Corporation or LLC
A business owner creates an S corporation when he or she elects to have an eligible entity (traditionally a corporation but also potentially a limited liability company) treated according to the rules of Subchapter S of the Internal Revenue Code and its related regulations. S corporations, therefore, really amount to a tax accounting classification rather than a legal entity.
In contrast, a business owner creates an LLC when he or she files an Articles of Organization or some similar document with the Secretary of State in his or her home state.
Default Tax Rules for Limited Liability Companies
While an LLC may typically elect S corporation treatment, if the LLC doesn't make this election, the tax accounting depends on whether the LLC is owned by one member or more than one member.
LLCs with one owner, or "member", can be disregarded (or ignored) for tax purposes. This "disregarding" just means that the owner reports the LLC's activities on his or her regular income tax return.
LLCs with multiple owners, or "members", can be treated as a partnership for tax purposes. In this case, the LLC files a partnership tax return and the partnership tax rules apply.
To sum up, the legal entity called an LLC can elect the S corporation tax accounting classification. (Many people, even professionals who should understand this, unfortunately don't.)
Tax Advantages of S Corporation Versus Single-member LLCs
A single-member LLC treated as a disregarded entity reports its income and deductions on a Schedule C tax form as a part of the member's 1040 if the LLC operates an active trade or business. This tax accounting means that the LLC owner pays self-employment taxes (roughly 15% on the first $120,000 of profits, roughly 3% on the next $80,000 to $130,000 of profits, and then roughly 4% after that on all of the rest of LLC's profits.
Note: The actual tax rates are 15.3% on the first $118,500, then a 2.9% tax until the taxpayer is subject to the 3.8% Affordable Care Act tax.
In comparison, a single-member LLC operating an active trade or business and treated as an S corporation files a corporate tax return and regular payroll tax returns. The S corporation status means that the business pays Social Security and Medicare taxes equivalent to self-employment taxes (again roughly 15% on the first $120,000 of profits and then roughly 3% to 4% on profits after that) only on the amount of profit called "wages".
To show you how powerful this self-employment tax saving gambit can be, suppose an LLC makes $100,000 in profits. If the LLC is treated as a sole proprietorship, the self-employment tax bill roughly costs $15,000 each year.
If the LLC elects S corporation treatment and the owner sets his or her wages to $50,000, the self-employment tax bill roughly costs $7,500 each year.
S corporation status in this example saves the owner roughly $7,500 annually in employment taxes.
Note: A single-member LLC that doesn't operate an active trade or business doesn't have to pay self-employment tax, and so would not save self-employment taxes by electing S corporation status.
Tax Advantages of S Corporation Versus Multiple-Member LLCs
A multiple-member LLC is treated as a partnership unless it makes an election with the IRS to be treated as a regular C corporation or as an S corporation.
As compared to a multiple-member LLC, an S corporation provides some significant advantages. Primarily, a partner's earnings from a partnership engaged in an active trade or business are subject to self-employment taxes. Accordingly, by electing to have a multiple-member LLC treated as an S corporation, the LLC saves the owners self-employment taxes in the same way that an LLC treated as a sole proprietorship saves its owner self-employment taxes.
This is a bit redundant, but to show you again how this self-employment tax saving works, suppose that an LLC makes $200,000 in profits and its two members each receive half of the profits. If the LLC is treated as a partnership, each partner receives $100,000 of earnings and each partner's self-employment tax bill roughly costs $15,000 each year.
If the LLC elects S corporation treatment and the owner wage amounts are set to $50,000, the self-employment tax bill roughly costs $7,500 per partner each year.
S corporation status in this example saves each partner roughly $7,500 annually in employment taxes.
Note: If an LLC has both members who actively work in the business and other members who can't make decisions and don't work in the business, the members can create a special type of LLC that also provides for self-employment tax savings even though the LLC is treated as a partnership. Typically, only large LLCs will have the resources to pay for the attorney and accountant help necessary to set up and cleanly operate one of these special LLCs. What makes the LLCs special, by the way, is that they comply with proposed Treasury Regulations dealing with LLCs that resemble limited partnerships by having both active, "general partner"-like members and passive, "limited partner"-like interests.
One other point should be made about the tax advantages of S corporations versus LLCs that have multiple members. As noted earlier, an LLC with multiple members is treated for tax purposes as a partnership. Partnerships are powerful tax-planning tools. A partnership presents its partners with many opportunities to save taxes. Partnership status also complicates the tax accounting. An LLC treated as a partnership requires more complicated and more expensive accounting than an LLC treated as an S corporation.
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
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