Tax Differences Between LLCs and S Corps

When it comes to choosing an appropriate corporate entity to protect their personal assets from the business creditors, many entrepreneurs end up deciding between a Limited Liability Company (LLC) and an S Corporation (S Corp). If you are one of those, let’s try to make your decision-making easier.

Whether to structure your enterprise as an LLC or an S Corp is not a one-size-fits-all choice as there are some fundamental tax differences between the two. What might be suitable for one business might be the opposite of what your business needs! Let’s take a look at how are these corporate structures differ from one another. With these basics under your belt, you can make a more informed decision.

IRS treats LLCs as a “pass through entity,” meaning that all of the business income and expenses are reported on an information return filed with the IRS, but the actual taxes are “passed through” to and paid by the shareholders or members of the entity.

Single-member LLC

Single-member LLCs are taxed as a sole proprietorship. This means that the sole owners of an LLC Start Up are accountable for all tax payments and filings. Owners report their business profits and losses on their individual personal income returns (Form 1040), and there is no need to file a separate business tax return with the IRS as a single-owner LLC is considered a “disregarded entity” for income tax purposes.

Multi-member LLC

Multi-member LLCs are taxed as a partnership. This means that the LLC itself does not pay any taxes directly to the IRS; instead, each LLC member is taxed on their rightful share of ownership in the company, as determined by the operating agreement. In a multi-owner LLC, each member reports their share on Form 1040, with Schedule E attached.

Because an LLC is classed as a separate entity from its owner, LLC owners are also required to pay a self-employment tax of 15.3% on income generated in the LLC. For example, if the net taxable income of your single-member LLC is $100,000 after deducting allowable business expenses, you would pay 24% personal income tax (under 2018 tax brackets) as well as a 15.3% self-employment tax on all profits, bringing your total tax liability to $24,000 + $15,300 = $39,300. (Note that this does not include additional payroll taxes and state corporate taxes that can be applicable.)

An S Corporation, which is named after subsection S of Chapter 1 of the Internal Revenue Code, operates as a corporation but is taxed on the individual shareholders’ tax forms. Every owner of an S Corp (shareholders) files tax returns based on their rightful share of ownership in the business and these taxes are reported on their individual Form 1040.

No Self-Employment Taxes!

The most significant difference between LLCs and S Corps is that S corps shareholders do not have to pay self-employment tax on their share of the business’s profits. Let’s say you are a shareholder in an S Corp who is paid $60,000 in salary. If the corporation has $100,000 of net profit and you will pay yourself the remaining $40,000 as a distribution, you would then only have to pay a self-employment tax of 15.3% on your salary of $60,000 instead of all business profits, plus a 24% personal income tax rate on the net profit, equaling your total tax bill to $9,180 + $24,000 = $33,180.

But there is a catch!

Before there can be any profits, each shareholder must be paid a “reasonable” salary, one that would be tied to industry standards and subject to payroll expenses like federal taxes and the Federal Insurance Contributions Act (FICA). In other words, the real savings of no self-employment tax on the net profit of your corporation only set in once the enterprise is bringing in enough that profits can be distributed to you as dividends, even after you pay the mandatory “reasonable salary.”

Do you want to enjoy the legal and structural benefits of an LLC, without sacrificing the tax benefits of an S Corp? You can choose to set up your business as an LLC but opt to file taxes as an S Corp. Legally, your business would still be an LLC. To the IRS, however, it would become an S Corp. It may sound confusing, but this is correct and permissible by the IRS.

Many factors should come into play when you are choosing between an LLC and an S Corp, but profitability should obviously be your priority. If you choose to structure your business as an S Corp, you get the advantage of paying less in total taxes. However, this is only a viable option if you are in a position to divide your business’s total income into two parts—one for salary and one for distributions. LLCs, on the other hand, take far less red tape to organize and are a lot cheaper to administer than S Corps. Besides, you can retain the structure of an LLC and still elect to be taxed as an S Corp – but you cannot do the reverse.

The experienced Chicago Business Lawyers at Bellas&Wachowski have the experience of over four decades of advising small business owners and can help you understand the differences between S Corp and LLC to figure out which corporate structure suits your business the most. Our counsel and advice can help you form a formal entity for your business that will offer you the most structural and tax advantages. Contact Senior Partner George Bellas for more information.