Should you form an LLC or a corporation?
That is a question a lot of people ask including myself. Which is easier? Which is cheaper and which saves the most in taxes.
As far as asset protection goes and protecting your personal assets from seizure, they both offer about the same protection.
But forming a corporation is more involved and more expensive to maintain.
With a corporation, you have a lot more formalities to deal with compared to a limited liability company. A corporation requires a board of directors and a shareholder agreement.
Corporations also must file their own tax returns with the IRS and possibly your state.
How much money in self-employment taxes can be saved by switching from flow thru LLC to s-corp tax status?
Switching from a flow-through Limited Liability Company (LLC) to an S-Corporation (S-Corp) tax status can potentially save you money on self-employment taxes, primarily Social Security and Medicare taxes.
However, the exact amount saved depends on various factors including your business’s net income, salary you pay yourself, and other deductions. Here’s a simplified overview of how savings can be calculated:
Self-Employment Taxes for LLCs:
As an LLC, all business profits pass through to the owners (members), who report this income on their personal tax returns.
The entire profit is subject to self-employment taxes (Social Security and Medicare), which is 15.3% (12.4% for Social Security on income up to the Social Security wage base, and 2.9% for Medicare with no cap, as of my last update in April 2023).
Taxes for S-Corps:
S-Corps also pass through income to owners, but owners are required to pay themselves a “reasonable salary” for the work they do in the business.
This salary is subject to Social Security and Medicare taxes, but it’s split between the employee and employer (the S-Corp), each paying half.
Profits distributed beyond the salary are not subject to self-employment taxes, only income tax.
Example of Potential Savings:
Let’s say your LLC earns $100,000 in profit. As an LLC, the entire amount is subject to self-employment taxes. If you elect S-Corp status and determine a reasonable salary is $50,000:
As an LLC, you’d pay 15.3% in self-employment taxes on the $100,000, which equals $15,300.
As an S-Corp, you’d pay Social Security and Medicare taxes on your $50,000 salary, which totals about $7,650 (split between you and the S-Corp). The remaining $50,000 in profit distributed to you would not be subject to these taxes.
In this simplified scenario, switching to S-Corp status could save around $7,650 in self-employment taxes.
However, there are additional considerations:
S-Corps require more administrative work, including payroll tax filings.
You must pay yourself a reasonable salary, which the IRS scrutinizes.
There may be state-level tax implications.
To get a precise calculation and ensure compliance with all tax regulations, it’s recommended to consult with a tax professional or accountant who can provide advice tailored to your specific situation.
What are the elements or factors IRS looks at to determine whether a salary is reasonable?
The Internal Revenue Service (IRS) considers several factors to determine whether the salary paid to an S-Corporation shareholder-employee is “reasonable” for the services rendered.
This assessment is crucial because it affects the taxes owed by both the S-Corp and the employee.
While the IRS has not provided a definitive formula for calculating a reasonable salary, the following factors are commonly considered in making this determination:
Industry Comparables: Salaries paid to employees in similar positions within the same industry can provide a benchmark for what is considered reasonable.
Employee Qualifications: The employee’s education, experience, training, and responsibilities within the company are considered to gauge if the salary is commensurate with their qualifications and contributions.
Nature and Scope of the Employee’s Work: The complexity and scope of the work performed by the employee are assessed. More responsibilities and higher-level tasks generally justify a higher salary.
Time and Effort Devoted to the Business: How much time and effort the employee puts into the business also plays a significant role. Full-time dedication often warrants a higher salary.
Dividend History of the Company: The IRS may look at how profits are distributed between salaries and dividends. A pattern that minimizes salary in favor of dividends may raise red flags.
Compensation Agreements: Formal agreements or policies for compensation within the company can provide a basis for determining reasonableness.
Financial Condition of the Company: The company’s profitability and revenue can influence what is considered a reasonable salary. The salary must be sustainable by the company’s financial performance.
Payment to Non-Shareholder Employees: Salaries paid to non-shareholder employees for similar roles can also serve as a guideline for what is reasonable.
Comparison with Previous Years: The employee’s salary history, especially if they have been with the company for many years, can be a factor in assessing reasonableness.
The IRS may use a combination of these factors in their evaluation and has discretion in their interpretation. It’s important for S-Corporations to document the rationale behind the salaries paid, ensuring they can justify the amounts as reasonable based on these factors.
Given the subjective nature of what constitutes a “reasonable salary,” S-Corporation owners are often advised to seek guidance from tax professionals to ensure compliance and minimize the risk of audits and penalties.
