When I’m advising clients on choice of entity, it frequently comes down to an LLC v S-corp. Both offer limited liability, both have the advantage of one layer of tax. When the ownership restrictions of an S-corporation aren’t an issue, it can sometimes be a very fine line between the two. When the business is closely held, these types of restrictions typically are not an issue. However, when the business only has a few owners, with at least some of the owners also working for the company, it can often make sense from a tax perspective to use an S-corporation.
When small business owners organize their business as an LLC, they will typically be subject to both income and self-employment taxes on their earnings. The self-employment tax rate for business owners is 15.3% of the first $117,000 of income for 2014 and 2.9% of everything above that. Using simple math, this can add up to a fairly large self-employment tax bill!
If you’re involved in the management of your business and organized as an LLC, you’re going to have to pay self-employment taxes, there just isn’t a way to avoid them. In contrast, using some simple tax planning, organizing the same business as an S-corporation often presents an opportunity to reduce your self-employment tax exposure. If organized as an S-corporation, small business owners may pay themselves a salary that is “reasonable,” pay employment taxes on that amount, and then extract the remainder of their earnings as dividends, which will not be subject to self-employment taxes. Using an LLC will not give you the same opportunity. Sounds simple, right?
Well, its not that easy. There are plenty of rules that you need to follow to ensure that your salary is deemed “reasonable compensation” by the tax man, and this opportunity isn’t available in every situation. However, when available, its not terribly difficult for a tax attorney or CPA to organize your affairs so that you may enjoy this tax planning device.
When the owners of a closely-held business are also actively managing their business, it often makes sense from a tax perspective to use an S-corporation instead of an LLC. However, this decision typically involves a number of tax and non-tax decisions, which can be surprisingly complicated. If you’re organizing your business, or interested in determining whether you can arrange your business to minimize your self-employment taxes by using an S-corporation, you really need to seek the advice of an attorney experienced in business planning. Failing to do so can lead to audits, penalties, and trouble that no business owner wants.
If you’re interested in seeing whether you can use an S-corporation to minimize your self-employment taxes, give The Eastman Law Firm a call, we’re happy to chat with you about whether this is an option for you!