Tax Considerations for Small Business Owners: S-Corp vs. LLC and Owner Pay
Tax Considerations for Small Business Owners: S-Corp vs. LLC and Owner Pay
As a small business owner before you begin operations you will need to decide as to the type of business structure you will be. Are you just a Sole-Proprietor, a Partnership, a Corporation, or a Limited Liability Company? Each classification or structure has its requirements and purposes. For example, if there are 4 business owners in the firm, the company cannot be a sole proprietor by definition. The decision is not as straightforward as that example, but several issues must be considered as to the structure of the firm. One issue that must be examined is the tax implication for the business owner. One of the largest considerations regarding tax implications is how will the Social Security/Medicare taxes be addressed.
S-Corp vs LLC
There are some big differences between LLCs and S-Corps. Indeed, the most important difference is that a S-Corp is not always a business structure, it can be a tax classification. This is one of the most important items to understand in this difference and it is likely the point that confuses most people or owners. A S-Corp is still a corporation that has been granted special tax status by the IRS and that status can be revoked by the IRS under certain conditions.
From a business structure standpoint, both LLCs and S-Corps offer the owner/owners the “corporate veil” that protects the owner’s assets. As a partnership and a sole proprietor, the company's assets are considered part of the owner's assets and vice versa. If an owner is sued either personally or by their business is sued, then all assets are subject to attachment via the suit. However, corporations and LLCs are an entity on their own and offer the owner more protection. The owner's assets are separated from the business assets as the corporation or LLC owns the assets. If your business could be subject to lawsuits, most people would suggest forming a separate entity for the company to offer this protection. However, since the business structure is a separate entity it will be taxed as an entity.
Owner Pay
For a LLC the owner's profits and pay are considered the same. Thus, it is subject to Social Security and Medicare Taxes. However, since an S-Corp is a corporation, the owner is considered an employee of the business, and the Social Security and Medicare taxes are paid via a payroll deduction. If the owner(s) receives a distribution of the profits, such as a dividend, then those funds are only subject to income taxes, not payroll taxes as they are not wages. You will likely see the issue here. What would prevent you from taking all you pay as dividends and going around the Social Security and Medicare Taxes? The simple answer in the past was nothing. However, the S-Corp tax classification, recall it is an IRS classification, not a structure, has as a requirement to qualify for the continued S-Corp classification- the owner as an employee must receive a “reasonable” salary. The question is what is classified as reasonable, and this could be a large issue for some. A reasonable salary is subjective and based on several factors- location, industry-standard pay, and even standard of living could be used as a factor in a reasonable salary. When determining how to pay the owner of an S-Corp, this is the main issue that must be considered, as it is the one most likely to cause issues for the owner’s taxes.
Tax Planning Tips
One of the biggest concerns for business owners is how to handle their Social Security and Medicare taxes. Indeed, one method that was used using an S-Corp was to call their pay dividend and thus eliminate these taxes. This was the main reason for the reasonable pay requirement. Thus, one planning tip for many owners is to find ways to reduce their Social Security and Medicare taxes. While there are some ways to reduce these taxes, they can be very complicated to implement, and to be successful they must be planned well in advance. Over the years the IRS has been very diligent in ensuring that loopholes for decreasing these taxes are strict and ensure that the taxpayer (owner) qualifies for the deduction. The most prudent move then is to begin talking with an accounting professional well in advance of using any legal strategy to reduce Social Security and Medicare taxes. This will give you the best opportunity to ensure that you adhere to the law and the deduction is safe to claim. We at Powell Finance Group do work with clients to discuss strategies and methods to maximize all your legal deductions to ensure that you are paying only the absolute minimum tax required. Call us for a consultation.
Conclusion
The tax differences between an LLC and an S-Corp can be very challenging. In discussing these challenges and differences it is important to always recall that a LLC is a business structure and a S-Corp is a tax status granted by the IRS. Indeed, a S-Corp is still a corporation and the entity must meet the requirements listed by the state of incorporation. While not mentioned previously it is possible that an LLC can be an investor in an S-Corp, but an S-Corp cannot be invested in an LLC. Always realize that there will be several "catch" items in business structures and tax planning. This is why it is always important to discuss with a professional consulting firm, such as Powell Finance Group, the ramifications of your business structure and tax decisions. Remember, the IRS grants S-Corp status and it is revocable, so ensure that you are meeting every legal requirement, especially when changes to the tax code occur, and you should plan to discuss tax planning strategies regularly with your consultants. For more information on the issues regarding the differences between LLCs and S-Corps, check out these articles-
