FORM AN LLC OR CORPORATION
FORM AN LLC OR CORPORATION
What is the Difference Between an LLC and S Corp?
An S corp is an IRS tax classification that can be elected by either an LLC or a corporation; an S corp is not a business structure like an LLC.
An LLC can file taxes under the "default LLC" classification, or it can elect the S corp classification (or the rarely used C corp classification).
Most small businesses file taxes under the default LLC tax classification. This is because small businesses don't usually carry over the amount of profit required to make the S corp tax designation beneficial.
Under an S corp, business owner(s) can save about 17 percent on the distribution portion of their income if the following statements are true:
- The business can pay the owner(s) a "reasonable salary".
- There are substantial distributions year over year.
- There is a positive return on investment for payroll service costs.
- The business meets S Corp requirements.
When to Use the S Corp Tax Classification
It only makes sense to file taxes as an S corp if there is enough profit carried over from year to year to pay owners a reasonable salary and substantial distributions.
The S corp tax classification allows business owners to be taxed as employees of an LLC. Under an S corp, the LLC business owner pays FICA (Medicare and Social Security Tax) and income tax on only their salary. Owner-employees pay only income tax on distributions.
S Corp Tax Benefit: When a reasonable salary is present, the owner pays FICA and income taxes on salary only. LLC distributions are only subject to income taxes.
The following criteria determine whether electing the S corp tax classification makes sense for an LLC:
- The LLC business owners must earn a "reasonable salary".
- The business should consistently earn a profit and pay distributions.
- The financial tax advantage must offset the cost of maintaining the S corp.
- The business must meet IRS S corp requirements.
Under an S corp election, LLC owners become employees. The IRS requires owner-employees to be paid a reasonable salary. A reasonable salary is any salary that you would pay someone to do the same job.
LLCs taxed as S corps are subject to increased scrutiny by the IRS. If the owner is not paid a reasonable salary, this may lead to the IRS denying S corp status and may lead to fines and back taxes.
Profit and Distribution
The S corp election allows a business owner to disburse an LLC's profit to owner-employees in the form of salary and distributions. The IRS then applies FICA and income taxes to only the salary. Distributions are subject to only income tax.
If the LLC doesn't earn enough profit to cover a reasonable salary and distribution, it won't make financial sense to elect the S corp tax classification. And, if the LLC owner(s) would like to forfeit salary for any reason, they could be subject to fines by the IRS.
Positive Return on Investment
It costs money to elect and maintain an S corp. Filing fees with the IRS are minimal but the additional bookkeeping and payroll costs are not. For LLCs that already have employees and payroll costs, this factor won't hold as much weight.
Business owners should weigh the cost of maintaining these services against the fiscal tax advantage of electing the S corp classification. Generally speaking, a reasonable salary plus $10,000 in annual distributions is often enough to make electing the S corp financially viable.
IRS S Corp Requirements
The IRS requires that businesses that elect the S corp status have 100 shareholders or less and they are only allowed to issue one class of stock.
The owners of the business must be US citizens or permanent resident aliens. Owners must also be private individuals and not business entities such as LLCs, corporations, or trusts.
When to Use the Default LLC Classification
Many LLCs will benefit most from the default LLC tax classification. LLC owners often put any profit back into their small businesses each year to promote growth. And without profit and distributions, there's no basis for electing an S corp.
Default LLC Tax Benefit: Business owners can choose to reinvest as much of the business's profit as they see fit in any given tax year.
The default LLC tax structure is best suited for businesses with these characteristics:
- Their owners reinvest profit back into the business to promote growth
- The cost of bookkeeping and payroll services would outweigh the tax benefit of an S corp
Reinvesting LLC Profit and Pass-Through Taxation
If you expect to reinvest most of the profit back into your small business, default LLC status is the right choice.
Small businesses usually carry very little profit from one tax year to the next. This is because small businesses usually spend most of their income on expenses like marketing, software, and office equipment to help the business grow. Some owners also want the choice to not pay themselves and that's not possible with an S corp classification.
When LLC owners choose to reinvest profit, very little net income (profit minus expenses) from the business will pass-through to the LLC member(s) individual tax returns.
Return on Investment
For some LLCs, the cost of hiring a payroll service and bookkeeper would outweigh the financial tax advantages of electing S corp tax classification. These LLCs would be best to operate as a default LLC.
Should Your LLC Elect S Corp Classification?
Whether or not an LLC should elect S corp status depends on how much profit the business is going to earn and carry-over from tax year to tax year.
Generally, if you know your business is going to have an annual distribution that is greater than $10,000 after paying yourself a reasonable salary, then your business has enough profit to justify becoming an S corp.
If you are unsure how much profit the LLC will make or if you want to reinvest the profits back into your LLC, it’s best to remain in the default LLC classification with the IRS. You can apply for an S corp status when it better suits your business.
To elect to become an S corp, file Form 2553 with the IRS.
Have a Professional Service Elect S Corporation Status For You
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S Corp Savings Calculator
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As a Sole Proprietorship or Single-Member LLC
Self Employment Tax:
Salary Employer Tax
(S Corp pays)
Savings on Self Employment Taxes
Against this savings, you have to balance the time and costs of running payroll and tax withholding. To learn more about what this will cost, get a free tax consultation.
LLC vs. S Corp: FAQ
What is an LLC?
LLC stands for limited liability company. An LLC is a relatively simple type of business structure that business owners can use to protect their personal assets. LLCs can have one or more owners called “members.”
How do I pay myself from my LLC?
How LLC owners pay themselves depends on how the LLC is taxed, the number of members, and any agreements regarding profit sharing and sweat equity
In a single-member LLC (SMLLC) or multi-member LLC (MMLLC), you can pay yourself:
- a distribution that passes through to your individual tax return, or
- a reasonable salary and distribution as an S corporation (S corp)
Our How Do I Pay Myself From My LLC guide will help you choose the best scenario for your small business.
What is an S corp?
An S corporation (S corp) is a tax designation for which an LLC or a corporation can apply.
Is an S corp an LLC?
No. An S corp is a tax designation for which an LLC or a corporation can elect.
How do you form an S corp?
You can form an S corp by filing Form 2553 with the Internal Revenue Service (IRS).
What are the requirements for an S corp?
S corps must meet four requirements:
- They can have no more than 100 shareholders.
- All shareholders must be private individuals (not other business entities).
- Shareholders cannot be nonresident aliens.
- The business may only issue one class of stock.
What are the benefits of an S corp?
Owners of S corps are considered employees of their company and they can save thousands of dollars on self-employment taxes as a result.
Which business structure is better for taxes — an LLC or S corp?
First, it’s important to note that an S corp is a tax designation — not a business structure. This means a company can be both an LLC and an S corp at the same time (i.e., an LLC that’s taxed as an S corp).
Businesses that carry over profit from year to year can sometimes benefit from electing the S corp classification.
Are taxes for LLCs and S corps the same?
No. The default taxes for an LLC and taxes for an S corp are not the same.
With an S corp, owners pay personal income tax and self-employment tax on a predetermined salary. They may then withdraw any remaining profits from the business as a “distribution,” which isn’t subject to self-employment tax.
With an LLC, all company profits pass through to the owners’ personal tax returns, and then the owners must pay personal income tax and self-employment tax on the entire amount.
Both LLCs and S corps benefit from a provision in the Tax Cuts and Jobs Act of 2017 that allows qualifying owners of pass-through entities to deduct 20% of qualified business income (QBI) from their tax returns. However, for S corps, the deduction doesn’t apply to profits paid out as wages.
Is an LLC or an S corp better for rental properties?
While it may depend on your specific circumstances, in general, a default LLC tax structure is better than an S corp for holding rental properties. This is because rental income is typically considered passive income, which means it’s not subject to self-employment tax.
Should an S corp own real estate?
Every situation is different, so it’s best to consult a tax attorney or other professional when deciding which tax structure is right for your real estate investment business.
What is a reasonable salary for an S corp?
Unlike the default LLC business structure, in which owners must pay self-employment tax on all of the company’s profits, owners of S corps are considered employees of the business and only have to pay self-employment tax on a salary they receive. Any other money they take from the company’s profits in the form of disbursements isn’t subject to self-employment tax.
S corp owners are required to earn a “reasonable” salary, which basically means a fair market rate based on the individual’s qualifications as well as their duties and responsibilities at the company. The purpose of this requirement is to prevent S corp owners from paying themselves an artificially low salary in order to pay less self-employment tax.
What is a distribution?
A distribution is a dividend that a shareholder/owner can take from the business profits that remain after a company pays all of its employee salaries. Shareholders must pay personal income tax on distributions, but distributions aren’t subject to self-employment tax.
What is pass-through taxation?
Pass-through taxation is a system of taxation that generally applies to sole proprietorships, partnerships, LLCs, and S corps. In this system, the profits or losses of the business are not taxed at the business level. Instead, they pass through to the owners’ personal tax returns and are taxed at each owners’ personal income tax rate.
What is the S corp tax rate?
There’s no corporate tax rate for S corps. Instead, owners of S corps pay personal income tax on the company’s profits. This rate depends on each owner’s personal income tax bracket.
Can I still use my DBA name if I elect to be an S corp?
LLCs and corporations that operate under a DBA name can choose the S corp election.