Taxation: S-Corp or LLC?

S-Corporation Wage Rules

Can an S-Corporation save taxes?

If the money you want to save is payroll expense, the answer is both "yes" and "no". The S-Corp will cost a bit more to maintain. You have to decide when that is worth it.


First the "yes".


An S-corp must pay its owner-shareholder a reasonable wage for performing the work of the S-corp. This means that in a normal employee/employer relationship should exist and the employee owner must be paid a "fair" wage because the IRS wants to collect payroll tax. 


Example 1:


You have an S-corp that does carpentry work. A carpenter makes about $50,000 a year in your area. Your S-corp has total earnings of $150,000, and profit (including your wages) of $100,000. It is not unreasonable for a company to pay a carpenter $50,000 as wages, so it isn’t unreasonable for your company to pay you the same - and pay payroll taxes on that amount because it seems to be "reasonable compensation" in your line of work in your geographical area.

The other $50,000 can be profit form the S-Corp not subject to payroll tax. It is similar to non-qualifying dividends paid thereby saving the owner over $6,000 in payroll taxes.

 

Example 2:

Same as above except you pay yourself $5,000 and use $95,000 as profits because you are very clever. Clearly that is unreasonable, and expect the IRS to come-a-knockin. They want their payroll tax - and they have an army of new people to try to pry it out of you. They will very likely recharacherize all of it as wages, make you pay the tax, penalties, and stand you in the corner to think about what you did.



Example 3:

You make only $20,000 because of the bad economy. In this case, you would have to pay out nearly all or all of it to satisfy the payroll tax police. So in this case, an S-Corp can not legally save you any money, and you probably shouldn't have it unless there is another reason for it – and usually there isn’t. Not only that but it will cost you more in tax reporting expense and payroll costs than would a simple sole-proprietorship.


Bottom line - if your business is successful, an S-Corp can save you money. If it isn't it will cost you money because not only will you pay the tax, you will have to pay the state corporate fees, the price of return preparation and minor other annoying costs of an S-Corp for an entity that may not be helping at all.

 

Single Member LLC

A single member LLC has default positions on your tax returns. The Limited Liability Company with more than one participant defaults to a partnership, and a 1065 partnership tax return must be filed indicating the income and expenses with the profit flowing to the partners. A sole-member LLC defaults to a sole-proprietorship, meaning it is filed on your individual tax return on Schedule C, the income taxable directly to the sole owner as self employment income.

You can pay yourself wages and then still have $50k remaining on your bottom line, but that $50K is taxed as self-employment earnings, not company profit, so in addition to income tax you must pay social security on the profit as well, which is almost as much as payroll tax. The difference buys you a tank of gas – or two.

You can elect “S-Corp status” for an LLC, meaning it is registered as an LLC, but treated as an S-Corp for tax purposes. This defeats the purpose, as you will still have to file an S-Corp tax return and the simpler method is to just form a corporation, elect S-Corp Status, and ignore the LLC.

 

Co-mingling

Get your mind out of the gutter, this is a tax term. Keep your corporate assets completely separate from your personal assets. Have separate bank accounts, move money from your business to your personal account methodically, strategically, and with reason. If you are found to have co-mingled assets, meaning your are mixing up your business and personal income and expenses making it difficult to determine what income or expenses are business and which are personal, the courts have ruled that since there is no clear difference between your personal accounts and your business, then the business and you are one and the same entity with no distinction between, removing the protective corporate shield. This will cost you additional tax and liability exposure. Since there is no disctiction, any kind of liability the company may have incurred could be considered your personal liability as well.  


ADVICE

Until you are certain your business will be profitable and very likely cause painful taxation - stay away from S-Corps. You will be only be asking for hassles and trouble and it will cost you additional tax reporting expense. If you are doing well, go for it. If not, and for whatever reason you believe you should have an entity other than a simple sole-proprietorship, an LLC will be just fine until you earn enough to make a difference. Regardless of whether or not you decide to incorporate, businesses should have liability insurance to cover whatever reasonable potential liability you may incur.