LLC Electing To Act As An “S” Corporation

Being Taxed as a Corporation

If you form a corporation, you can incorporate as a C corporation or as an S corporation.

C corporation.

As a C corporation, you will pay corporate income tax on what the corporation earns and then you pay income tax on any salary you pay yourself.

Because you are an employee, you do not pay self-employment tax, but the corporation pays the employer’s portion of those taxes.

S corporation.

An S corporation is called a pass-through entity.

The corporation itself pays no income tax at all.

You can use the funds earned by the corporation to pay yourself in two ways:

1) You pay yourself a salary;

As an individual, you will pay self-employment tax only on the salary you pay yourself, not on all the funds your corporation earns.

2) You pay yourself “distributions” (cash payouts) from the S corporation and not have to pay self-employment tax on those funds.

This is where the savings come in.

By separating the income earned by the corporation into two separate methods of payment to you as the individual,

you avoid self-employment tax on funds paid as a distribution.

Note that you have to elect to be taxed as an S corporation for this to apply.

Otherwise, you will automatically be classified as a C corporation.

These benefits apply if you are an LLC that chooses to be taxed as an S corporation as well.

Choosing to set up your business as an LLC or corporation can reduce the amount of self-employment taxes you will have to pay.

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LLC vs Self Employed: Everything You Need to Know

Being treated as an LLC vs. self-employed person can make a world of a difference in the amount of taxes you pay.

If you’re an employee, the employer will pay 50 percent of your Medicare and Social Security taxes.

1. Self-Employment Tax Rates
2. Taxes for Corporations and LLCs
3. Avoiding the Self-Employment Tax
4. How To Be Taxed as an S Corporation
5. What Is an LLC?

Updated October 29, 2020:

Being treated as an LLC vs. self-employed person can make a world of a difference in the amount of taxes you pay.

If you’re an employee, the employer will pay 50 percent of your Medicare and Social Security taxes.

If you’re self-employed, you have to take care of all your taxes yourself.

The tax you pay as self-employed is called the self-employment tax, and you might be able to reduce its amount by forming a limited liability company or a corporation.

Self-Employment Tax Rates

Self-employment tax rates are:

12.9 to 15.3 percent for Social Security paid on the portion of your income up to $117,000

2.9 percent for Medicare plus an additional 0.9 percent on yearly wages over $200,000

Sole proprietors, partners in a general partnership, and members of an LLC that’s taxed as a disregarded entity must pay self-employment taxes.

Many businesses make estimated quarterly payments to the IRS to avoid being surprised with a large yearly bill and costly fines or penalties.

You can estimate your taxes with an online tax calculator.

Taxes for Corporations and LLCs

Unlike partnerships and individuals, the IRS treats all corporations like C corporations automatically.

The corporation pays income tax on earnings, and its owners, also called shareholders, pay some personal income tax on the amounts they receive as well.

Many small businesses choose to pay taxes as S corporations instead.

An S corporation doesn’t pay corporate income tax, and its shareholders report the company’s income on their personal returns.

An LLC can be taxed as a disregarded entity, which means that it is taxed as a sole proprietorship or a partnership.

It can also be taxed as an S corporation. Partners in a limited partnership or a partnership that’s taxed as a corporation are not self-employed.

The owners or shareholders of corporations receive income from dividends.

Because this income isn’t from self-employment, it’s not subject to the self-employment tax.

Compensation from your corporation is employment income, so employees pay the employee tax rate rather than the self-employment rate.

Avoiding the Self-Employment Tax

If you’re a sole proprietor, a partner, or an LLC that’s a disregarded entity, you’ll pay Medicare and Social Security taxes on your percentage of your company’s net income or profits.

If your business is an S corporation or an LLC that’s considered an S corporation, you’ll pay Medicare and Social Security taxes only on the salary you receive, not on your company’s other profits.

You can’t avoid self-employment taxes entirely, but forming a corporation or an LLC could save you thousands of dollars every year.

If you form an LLC, people can only sue you for its assets, while your personal assets stay protected.

You can have your LLC taxed as an S Corporation to avoid self-employment taxes.

However, you may not need an LLC if you have a good professional liability and property insurance coverage and do not have many assets.

How To Be Taxed as an S Corporation

To form a corporation or an LLC, you must file the correct documents with the secretary of state or another designated agency in the state where your company is located.

The IRS automatically taxes all corporations as C corporations that pay corporate income tax.

It taxes LLCs as disregarded entities whose owners pay self-employment tax on all their earnings.

To be considered an S corporation by the IRS, you must file form 2553. If your company is an LLC, file form 8832.

What Is an LLC?

Owners of an LLC can take advantage of limited liability, like the owners of a corporation.

LLCs can also pass through profits to the owners, so they’re taxed at the lower individual rate.

There are no limits on the number of owners an LLC can have.

LLCs can file taxes as sole proprietors, also called single-member LLCs.

They can also file taxes as S corporations or partnerships.

The costs of creating an LLC depends on the state you want to do business in.

A single-member LLC protects your personal assets from the creditors.

Setting up an LLC also lets you avoid paying personal and business taxes on your freelance income.

As a pass-through entity, all the income and expenses of an LLC get reported on your personal income tax return.

If you need help with LLCs vs. self-employed businesses, you can post your legal need or post your job on UpCounsel’s marketplace.

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One of the fundamental differences between corporations and partnership business entities is that the former faces “two tiers” of taxation – once at the corporation level, and again when profits are distributed as dividends to the shareholder – while the latter are only taxed once to their owners as “pass-through” entities. Of course, the reality is that there are a lot of factors that go into determining the right kind of business entity, beyond just the pass-through taxation treatment or not, though in practice it is often a material factor.

A hybrid mid-point between the two is an S corporation, which is recognized as a corporation for legal purposes – including for liability protection, and transferability of stock shares – but still taxed as a pass-through business, similar to a partnership.

However, in practice the pass-through tax treatment of an S corporation isn’t exactly identical to a partnership, because with a partnership all pass-through income is subject to self-employment FICA taxes (as high as 15.3%), while an S corporation only pays FICA taxes on salary compensation to its owners, and not the remaining profits paid out as nontaxable dividend distributions.

To prevent everyone from just converting partnerships into S corporations that all pay their owners $0 in salary – to completely avoid FICA taxes – the IRS still requires that S corporation owner-employees be paid “reasonable compensation” for the services they render to the business.

Nonetheless, the reality is that for highly profitable businesses, especially with multiple owners and/or multiple employees, there is clearly a portion of profits, over and above just reasonable salary compensation, that can be distributed as a dividend to the S corporation owners, saving FICA self-employment taxes in the process. For profitable businesses, the tax savings can be thousands or even a few tens of thousands of dollars in savings.

Ultimately, not all small businesses can take advantage of these rules. Some don’t meet the ownership requirements of an S corporation, and others are so small and dependent on their owners that realistically, “reasonable” compensation would be 100% of the business profits anyway. Nonetheless, there are many high-income partnerships (or LLCs taxed as such) that might benefit by switching to an S corporation (or making an election for the LLC to be taxed as an S corporation), specifically to split the business profits into FICA-taxable wages and FICA-exempt S corporation dividend distributions. At least, until or unless Congress shuts down this perceived “loophole” and reunifies the taxation of S corporation dividend distributions with the pass-through income of partnerships!