If you're self-employed, you'll usually have to pay higher Social Security and Medicare taxes, collectively known as self-employment taxes, than if you were an employee of a company. One way to help avoid these higher taxes is to organize your business as an S-corporation. The Internal Revenue Service may take a close look at your taxes if you choose this route, as you could end up lowering your overall tax liability while generating the same net income. Show Self-employment taxesWhether you're self-employed or an employee, you'll have to pay Social Security and Medicare taxes to the government. When you work for someone else, you're only responsible for part of these taxes, while your employer pays the balance. However, if you're self-employed, you have to pay both portions of this tax. The combined employee and employer portions of this tax amount normally amounts to 15.3 percent. S-Corp distributionsIf you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You'll still be liable for self-employment taxes on the salary portion of your income, but you'll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation. Risks of S-CorporationsThe IRS tends to take a closer look at S-corporation returns since the potential for abuse is so large. For example, if you make $500,000 in one year but only designate $20,000 of that as salary income, you might trigger an IRS inquiry, since you are avoiding so much self-employment tax. The guiding principle is that you must designate a "reasonable" amount of your income as wages, rather than a distribution. What constitutes "reasonable" can often be a gray area, but if you push the envelope too far, you put yourself at risk for an IRS audit and potentially penalties and interest on any back taxes assessed by the IRS. Additional costs for S-CorporationsWhile an S-corporation may save you in self-employment taxes, it may cost you more than it saves. As with larger corporations, an S-corporation has both start-up and ongoing legal and accounting costs. In some states, S-corporations must also pay additional fees and taxes. For example, in California, an S-corporation must pay tax of 1.5 percent on its income with a minimum annual amount of $800. This tax is not required for sole proprietors. With TurboTax Live Full Service Self-Employed, work with a tax expert who understands independent contractors and freelancers. Your tax expert will do your taxes for you and search 500 deductions and credits so you don’t miss a thing. Backed by our Full Service Guarantee. You can also file your self-employed taxes on your own with TurboTax Self-Employed. We’ll find every industry-specific deduction you qualify for and get you every dollar you deserve. As we said, an LLC is a legal business structure, whereas an S corp is a tax filing status. But let’s compare a standard LLC to an LLC with S corp election. First, we’ll examine the advantages an LLC with S corporation election has over an LLC without S corporation election. Advantages of S Corp Over LLCAs we just explained, the members of a standard LLC can’t be employed by the business. The money they make from the LLC comes from distributions, a.k.a. their share of the profits. They must then pay 15.3% in self-employment tax on all those profits. If the LLC is particularly profitable, that can add up to a sizeable chunk of change. An LLC with S corporation election can pay its members in two ways, in distributions and a salary from the LLC. In that case, the members would only pay employment taxes (Social Security and Medicare) on their salary from the LLC, but not on the distributions. Again, in a more profitable business, the tax savings can add up. Money paid out as salary is also a tax-deductible expense for the business. Advantages of LLC over S CorpTraditional limited liability companies also have some advantages over those with S-corp election: Requirements for S CorporationsThe Internal Revenue Service (IRS) has stricter requirements for businesses with S corp designation. For an LLC or corporation to qualify for S corporation election, the Internal Revenue Code says they must:
As you can see, these restrictions would limit the number and type of members an LLC set up as an S corporation could have. A traditional LLC could have more than 100 members and be owned by corporations, partnerships, and non-resident aliens. More IRS ScrutinyRemember what we said about LLC members being required to pay themselves a “reasonable salary”? The IRS watches this closely to prevent abuse. If your salary is inadequate, you’re not contributing enough to Social Security and Medicare. That’s why the IRS expects you to pay yourself a reasonable salary. But how does the IRS define “reasonable compensation”? The instructions on Form 1120-S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” While those instructions don’t provide a 100% clear definition, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning for the same work. All of this means that a business with S corp designation is more likely to be audited than one without. And, if the IRS decides that your salary is not reasonable, it has the authority to reclassify your non-wage distributions (which are not subject to employment tax) to wages (which are subject to employment tax). Several court cases have supported the IRS’s right to do this. Additional Accounting and BookkeepingHaving an LLC filing as an S corporation generally means more paperwork. If you don’t already have to do payroll and calculate payroll taxes for your business, being an owner-employee means that you’ll have to do so. Your taxes will be more complex, as well. With these added complications, you’re likely to have higher administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software. How We Can HelpNow that you understand the difference between LLC and S corp, you’ll have to weigh all the factors to see which choice best fits you and your business. We don’t recommend doing this alone, though. It’s times like these when you need a skilled tax professional to help you make an informed decision. If you’re planning to start an LLC, with or without the S corp designation, we can handle the process for you. Our LLC formation service sets you up with experts who can file the paperwork with the state for you. And, if you’d like to form your LLC as an S corp, our S corporation service can take care of that added step, too. Once you’re established, we have other services like Worry-Free Compliance to help you stay compliant with government regulations. You can do this. We can help. Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional. |