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LLC and S Corp: The Best of Both Worlds

The Best of Both Worlds- LLC and S Corp

You have a successful business and you very wisely registered your business as a limited liability company vs. an s corp because of its simplicity, flexibility and, whether or not you knew this, an LLC can provide even more liability protection than a corporation.

Now some friends, or maybe even your accountant, are telling you that had you formed your business as a corporation, instead of an LLC, and elected to be taxed for federal income tax purposes as a Subchapter S corp, you would be paying less in federal taxes. They may be quite correct. However, you don’t have to give up the simplicity, flexibility or asset protection that your LLC can provide to get the tax advantages of being taxed as an S Corporation.

An LLC can choose to be taxed as an S Corp

You can have both the advantages of an LLC and Subchapter S corp- or even, just to confuse things- a Subchapter C corporation . The key is that for federal tax purposes, an LLC does not have its own tax scheme; rather an LLC can choose how it will be taxed by “checking the box” on the Form 8832:

  1. A single member LLC can choose to be taxed much as a sole proprietor- the LLC is disregarded entirely for federal tax purposes. A single member LLC can also be taxed as either a Subchapter S or C corporation.
  2. A multi-member LLC can choose to be taxed as a partnership or as either a Subchapter S or C corporation.
    Regardless of the tax election, the LLC will be maintaining its status as an LLC under state law.

Why a tax savings when electing to be taxed as an S Corp?

So, why is there a tax savings to an LLC that elects to be taxed as a Subchapter S Corp? When you are taxed as a sole proprietor or as a partnership, all net income is passed through to the member(s) as income and reported on the individual member’s personal tax return and it is all counted for the purposes of the federal self-employment tax at a rate of 15.3%. It is the equivalent of the FICA and Medicare tax which is deducted from your pay if you are paid via payroll and it includes both the employee’s share and the employer ‘s share.

S Corp minimizes overall tax liability

A key feature of the S corporation is its ability to minimize overall tax liability for you and your business. Because of its nature as a corporation, only the wages paid to its owner/employees are earned income subject to FICA tax for Social Security and Medicare. If your company is successful enough, you can split member’s compensation into two parts: pay a salary via payroll that is “reasonable” for a company that size and type and then pay another amount – distribution of “profit”-directly to the member. This would be analogous to a dividend and that distribution is not subject to the self- employment tax.

An Example of S Corp Federal Taxation:

Normal Associates, LLC is a multimember LLC. It has two members, Ted and Sally and is quite successful. The company is taxed as a partnership and has a profit of $220,000 which is allocated to Ted and Sally equally. Ted and Sally report this on their individual 1040’s and, in addition to whatever federal income tax they owe, each pays 15.3% as self-employment tax. 15.3% of $110,000 is $16,830 each or $33,660 combined.

Ted and Sally have a very good lawyer and a very good accountant so they change the way the LLC reports its taxes to that of a Subchapter S corp. Each take $50,000 in salary (an amount that is reasonable based upon market rates for their role in the company) and have income tax and FICA/Medicare taxes withheld. The company then distributes $60,000 to each as their share of the profits. Obviously, this amount along with their salary is added to their gross income for income tax purposes but the $60,000 is not subject to the self-employment tax so each save 15.3% of $60,000 or $9,180 each or $18,360 combined per year. The company remains an LLC for state law purposes and maintains all those advantages- simplicity, flexibility and increased liability protection- the Best of Both Worlds.

About the Author

Dwight Sowerby