OG Article: LLC Taxed as an S-Corp (Form 2553)
LLC & S-Corp Taxation
S- Corp is a shortened term for S-Corporation. An S-Corporation, sometimes called a “Subchapter S Corporation) is different from an LLC or Corporation (C-Corporation) as it is considered a “tax entity” instead of a legal entity at the state level.
Tax entity refers to a tax classification status created with the IRS. This S-Corporation election is made with the IRS and is “placed over” your legal entity (an LLC or C-Corporation).
The S-Corporation is considered a “pass through” tax entity. Therefore, it is not subject to double taxation that a C-Corporation would be. All income, losses, credits, and deductions go through to the owners (share-holders). They are then reported and paid for on the owner(s)/share-holders personal tax returns.
Similar to an LLC and C-Corporation, an S-Corporation extends personal liability protection to its owners. Personal assets such as homes, vehicles and bank accounts are protected in the circumstance of a lawsuit and cannot be used to pay off the S-Corporation’s debts and/or liabilities.
Setting up an S-Corp
Again, an S-Corporation is a tax entity selection made with the IRS, it is not a business entity like an LLC or C-Corporation. You must first have an already formed entity in order to “set-up” this taxation. Thus, an S-Corporation is “set up” and not “formed”.
When the phrase “form an S-corp” is used, it actually refers to forming a C-Corporation with the state, then choosing to be taxed as an S-Corporation with the IRS.
An LLC can also elect to be taxed as an S-Corporation with the IRS.It is especially common with LLC’s whose net income averages $75,000 to $100,000 annually.
We will be focusing on LLC’s being taxed as S-Corporations for all intents and purposes of this article.
IRS Tax Classifications for LLC’s
Depending on how many members an LLC has, there are default tax statuses:
- Single-Member LLC’s are taxed as a Disregarded Entity/Sole Proprietorship.
- Multi-Member LLC’s are taxed as a Partnership.
By filing an additional form after receiving an EIN for your LLC, you can request the IRS to tax you as a Corporation.
- You can have it taxed as an S-Corporation by filing Form 2523.
- You can have it taxed as a C-Corporation by filing Form 8832.
Quick Tip: While S-Corporations are growing increasingly popular among small business owners with adequate net income, they are the least understood and should not be approached too hastily.
S-Corp Benefits: Saving money on Self-Employment Taxes
Self-employment tax references Social Security and Medicare taxes. These total approximately 15.3% of your net income (12.4% for Social Security and 2.8% for Medicare) and are paid to the Social Security Administration. You report this as part of your federal tax return (Form 1040).
An S-Corporation saves money on self-employment taxes by “splitting” income into two groups:
- Salary: wage or payroll.
- Distribution: dividend or profit.
Upon having your LLC taxed as an S-Corporation, you are now an “employee-owner”. Thus, now owning and working for your company.
Having this income “split” means only paying 15.3% self-employment tax on your salary. Money left over (known as distributions) is not subject to self-employment tax.
Unlike an LLC taxed as a Sole Proprietorship or Partnership, you don’t pay self-employment tax on all of your net income as there is no option to “split” your income and save money on this tax.
To avoid abuse of this taxation option, the IRS created a loophole: they require you to take what’s called a “reasonable salary”.
For example, if your LLC has a gross income of $160,000 and your expenses are $40,000, your net income is $120,000. You and your accountant may decide on a reasonable salary of $70,000 per year (which is average for your industry). You will pay 15.3% self-employment tax on the $70,000 wage, but the remaining $50,000 will not be subjected to this tax. You’re now saving $7650 (15.3% of remaining $50,000).
It’s important to note that your administrative costs will offset your savings a little. However, for most businesses with a net income of $75,000 to $100,000 per year (or more), the tax savings are typically more than the expense total.
S-Corp Administrative Responsibilities
Having the S-Corp tax entity requires you to adhere to certain administrative responsibilities. They include:
- Running payroll
- Filing quarterly payroll returns at the state and federal level
- Keeping accurate books and balance sheets
- Hiring an accountant is strongly recommended. They will file your corporate tax returns which include Form 1120S, K-1’s for shareholders/owners and other relevant documentation.
- Depending on the state in which you are located and number of employees, you are also required to have federal unemployment insurance, state unemployment insurance and worker’s compensation insurance.
- Payroll can get tricky. There may be anywhere from 5-10 federal and state payroll forms you are required to file. Be sure to ask your accountant for good payroll companies.
All of these administrative tasks will most likely cost money. Annually, costs will vary. However, payroll averages $400-$600, accounting & bookkeeping averages $400-$600, and tax-preparatory services averages $700-$1,000. Therefore, total administrative costs can be around $1500-$2500 annually. We recommend planning for more, as prices are subject to fluctuation and can change.
As we mentioned before, S-Corporations are among the least understood. Be sure to do your research before deciding to go this route! There are important considerations to make and understand.
- Audit Risks are Higher
- S-Corps are surveilled closely by the IRS, so it’s important to take a reasonable salary and ensure state and federal taxes are filed correctly.
- Social Security Benefits
- In the context of an S-Corporation, social security benefits are based on the reasonable salary paid to you. It’s important to remember that the profit distributions are not accounted for in this. While you’ll be saving on self-employment taxes, you could potentially reduce the Social Security benefits you will have access to in the future.
- Pre-approval on Mortgages
- Banks will look at your income when determining how much you can afford with a traditional mortgage. They will only take the salary paid by the S-Corp, no dividends included. Be mindful about setting a reasonable salary, setting it too low could compromise your ability to purchase a home depending on how much it costs.
- Retirement: Self Employed Account Contributions
- Having a self-employed retirement account (ie. SEP, simple IRA, 401(k) or Keoghs) means contributions you can make are based solely on the salary paid by the S-Corp.
Choosing a Reasonable Salary
General factors to consider:
- Experience level, training and certifications
- Nature of tasks and responsibilities
- Dividend payout history
- Amount of time and level of effort provided to the business
- Similar business and position salaries
- Relevant formulas used to determine salary
- If applicable, regular employee salaries
- Document how you spend your time serving the business. Find out what the appropriate salary is for those kinds of activities. Making note of this using percentages of your hourly workweek is a great system to use.
- Use your accountant, payroll company or sites like Indeed and Glassdoor who list actual salaries and average them. Save and print them to provide appropriate documentation when justifying your salary.
- If your role encompasses a mixture of more general positions:
- Develop hourly percentages for each role based on how much time is spent on them over a weekly work period.
- Find the average salary for each role.
- Calculate general salary based on averages.
- It is generally recommended that distributions should be no more than 3x a salary. If net income is $180,000 and a salary is $80,000, distributions are $100,000.
- It is also generally recommended that distributions should be kept to 50% of net income. If net income is $180,000 and a salary is $90,000, distributions are $90,000.
Nevertheless, make sure to consult with a professional to choose the best taxation structure for your business.