Two of the most popular entity structures preferred by small-business owners are S-corporations and Limited Liability Companies. Both structures allow for income and losses to “pass through” the business to be reported on the owner’s individual tax returns, without taxation of the entity itself.
One major difference between the two structures is that owners of LLCs must pay self-employment tax on business earnings, while S corp owners do not have this tax liability. LLC owners must pay 15.3 percent tax on the first $117,000 of income, plus 2.9 percent in Medicare taxes on their self-employment income totaling more than $117,000. However, keep in mind that an LLC can elect S corporations oration status for income tax purposes.
Alternatively, S corp owners only pay self-employment tax on their salary, which amounts to 7.65 percent on the first $117,000 in salary earned in 2014. After meeting this threshold, only 1.45 percent of Medicare taxes are withheld. The employer portion mirrors the individual’s Medicare and Social Security withholdings. Distributions from the corporation are not subject to FICA withholding — potentially a large tax savings. S corp distributions are your share of the company’s profits, and considered the return for your investment in the company. The company’s taxable income flows through to shareholders on form K-1. As an owner, you pay federal and state income taxes on this income at your individual income tax rates.
IRS auditors pay close attention to the salary that S corp owners pay, or do not pay themselves. The problem, as the IRS sees it, is some S corporation owners may be tempted to give themselves artificially low salaries; thus, reducing the amount owed in Social Security and Medicare payroll taxes. Owners then take distributions to make up for the shortfall.
To avoid a problem with the IRS, be sure to draw pay that would be considered a reasonable salary. You can check with a national association to determine an average executive salary for your industry. Once you have determined a reasonable salary, there is no reason why you shouldn’t take additional money from the corporation as distributions. You can save still save money for yourself and your corporation by taking out distributions rather than a salary. As your company grows and develops, make sure to adjust your salary and distributions as necessary.
S corps may provide a tax savings, but LLCs are not without advantages, as they can allow more flexibility to business owners. The LLC structure allows owners to distribute profits in any manner they see fit. For example, you and a partner own an LLC, your partner contributed $40,000 for capital, and you contributed only $10,000; however, you perform 90 percent of the work. You both decide that, in the interest of fairness, you will share the profits 50/50. As an LLC, you can make that decision, whereas with an S corp, you cannot. A tax adviser with experience in small-business taxes should be able help guide your decisions in these areas.