Over the course of my career, the most frequent conversation I’ve had with prospects and clients alike deals with what entity they use should to operate their new or existing business. This is going to be the subject of my first special report so if you haven’t subscribed yet, I highly recommend you do because it’ll be out in the next week or two. For now though, what I’m going to touch on is probably one of the more interesting aspects of utilizing an S-Corporation over a limited liability company (LLC) and that’s the potential to save on payroll taxes. I hate to use the word loophole because this specifically in the Code but it’s also something Congress has been trying to “fix” so be sure if you take advantage of this, you keep up to date on what is happening. There have been two attempts to slip “fixes” into other legislation but both times they’ve been knocked down.
What am I talking about? If you operate under an LLC, the earnings from your business is subject to self-employment tax which in 2012 is 13.3% (this is set to go back up to 15.3% in 2013). If you operate under an S-Corporation, you’re required to pay yourself a “reasonable” salary (we’ll get back to that) but the same earnings that were subject to self-employment tax by using an LLC aren’t there under an S-Corporation. Of course, the amount you pay on your “reasonable” salary is subject to those same taxes so you lose any benefit on that amount.
So let’s look at an example. Keeping it simple, your company makes $100,000 (net taxable income). Using an LLC, if you owned this business 100%, you’d have to pay income tax AND self-employment taxes on this amount. Now say this same company is using an S-Corporation structure and your salary is $50,000. Now you’re paying income and payroll taxes on the $50,000 salary but only income taxes on the remaining $50,000. The net effect is about a $6-$7k tax savings. Not too bad.
Now let’s get to the downside. First off, you’d better be able to justify your “reasonable” salary. If you’re the sole owner and the sole employee, there can be an argument that the entire $100,000 should be your salary. This is where you want to document why you’re doing what you’re doing. Maybe the average salary in your area is $50,000 and you’re using the rest of the money to reinvest in the business at a future point in time. Be ready to justify the amount. If you have employees, it gets easier to justify a less then 100% salary because then there’s aspects of the business that can more easily be considered a distribution on an investment (i.e. your business).
S-Corporations are also more administratively burdensome. Since you’re on the payroll, you have deposits to make and quarterly as well as annual payroll filings. That by itself can chew up some of that tax savings in either time or money. You’ll also have to pay unemployment tax. So in short, an LLC is easier, but if you operate under an S-Corporation and can justify a salary less then the full amount the company makes, there can be some tax savings there.