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, or a limited liability company. Before I discuss the relative tax advantages of S corporation versus LLCs, however, I should go over the basics of s corporation and llc taxation. Basics of S Corporation versus LLC Taxation S corporations are created when an eligible entity (traditionally a corporation) elects to be treated according to the rules of Subchapter S of the Internal Revenue Code and its related regulations. S corporations, therefore, are really a tax accounting classification rather than a legal entity. An LLC, in contrast, is actually a legal entity created by state law through the filing of articles of LLC formation or some similar document. A second important point: An LLC is a chameleon for tax purposes. An LLC with one owner, or member, can be disregarded (or ignored) for tax purposes. And this “ignoring” or “disregarding” just means that the LLC’s activities are reported on its owner’s regular income tax return. The one-member LLC can also elect to be treated as a regular corporation, called a C corporation, or it can elect to be treated as an S corporation. (In the language of the applicable Treasury Regulations, an LLC is an “eligible entity.”) An LLC with multiple owners, or members, can be treated as a partnership for tax purposes. Or the multiple-member LLC can elect to be treated as a regular corporation or, again, as an S corporation. To sum up, the legal entity called an LLC can elect to use the S corporation tax accounting classification. (Many people, even professionals who should understand this, don’t unfortunately.) Once you understand these two points, you can more easily understand the tax advantages of S corporation versus LLCs status. Tax Advantages of S Corporation Versus LLCs: Singlemember LLCs A single-member LLC treated as a disregarded entity reports its income and deductions on a Schedule C tax form if the LLC operates an active trade or business. This tax accounting means that the LLC owner pays self-employment taxes (roughly 15% on the first $100,000 of profits and roughly 3% therefore) on all of the LLC’s profits. In comparison, a single-member LLC operating an active trade or business and treated as an S corporation has to file a corporate tax return and regular payroll tax returns. However, the S corporation status means that the business pays Social Security and Medicare taxes equivalent to self-employment taxes (again roughly 15% on the first $100,000 of profits and then 3% on profits after that) only on the amount of profit called “wages.” To show you how powerful this self-employment tax saving gambit can be, suppose that an LLC makes $100,000 in profits. If the LLC is treated as a sole proprietorship, the selfemployment tax bill roughly costs $15,000 each year.
If the LLC is treated as an S corporation and the owner wage amount is set to $50,000, the self-employment tax bill roughly costs $7,500 each year. S corporation status in this example saves the owner roughly $7,500 annually in employment taxes. Note: A single-member LLC that doesn’t operate an active trade or business doesn’t have to pay self-employment tax and so would not save self-employment taxes by electing S corporation status. Tax Advantages of S Corporation Versus LLCs: Multiplemember LLCs A multiple-member LLC is treated as a partnership unless it makes an election with the IRS to be treated as a regular C corporation or as an S corporation. As compared to a multiple-member LLC, an S corporation provides two significant advantages. First, a partner’s earnings from a partnership engaged in an active trade or business are subject to self-employment taxes. Accordingly, by electing to have a multiple member LLC treated as an S corporation, the LLC saves the owners self-employment taxes in the same way that an LLC treated as a sole proprietorship saves its owner self-employment taxes. This is a bit redundant, but to show you again how this selfemployment tax saving works, suppose that an LLC makes $200,000 in profits and has two members who each receive half of the profits. If the LLC is treated as a partnership, each partner receives $100,000 of earnings and each partner’s selfemployment tax bill roughly costs $15,000 each year. If the LLC is treated as an S corporation and the owner wage amounts are set to $50,000, the self-employment tax bill roughly costs $7,500 per partner each year. S corporation status in this example saves each partner roughly $7,500 annually in employment taxes. Note: If an LLC with multiple members has both members who actively work in the business and other members who can’t make decisions and don’t work in the business, a special type of LLC can be created that also provides for self-employment tax savings even though the LLC is treated as a partnership. Typically, only large LLCs will have the resources to pay for the attorney and accountant help necessary to set up and cleanly operate one of these special LLCs. What makes the LLCs special, by the way, is that they comply with proposed Treasury Regulations dealing with LLCs that resemble limited partnerships by having both active “general partner”-like members and passive “limited partner”-like interests. One other point should be made about the tax advantages of s corporations versus LLCs that have multiple members. As noted earlier, an LLC with multiple members is treated for tax purposes as a partnership. Partnerships are wonderfully powerful tax planning tools. A partnership presents its partners with a myriad of opportunities to save taxes. However, partnership status also complicates the tax accounting. An LLC treated as a partnership, for example, requires more complicated and more expensive accounting than an LLC treated as an S corporation. Saving Business Taxes with an S Corporation: A Short Primer
S corporations, or Subchapter S corporations, produce several tax benefits as compared to sole proprietorships, partnerships, and C corporations. The big benefit—and the one that people usually talk about— are the payroll tax savings. To understand how this works, let me compare two alternatives: A sole proprietor making $90,000 a year and an S Corporation making $90,000 a year. Of course the taxes that a sole proprietor pays depends on his or her filing status, itemized deductions and family size, but typically such a person might pay about $12,000 in federal income taxes. The person might also pay another chunk in state income taxes. In addition to these income taxes, the proprietor also pays a 15.3% self-employment tax on the $90,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social security and Medicare tax) equals $13,000.
unemployment tax on the owner’s salary. (This can be as much as $400 or so annually per owner.) * An S Corporation is restricted in both the type and number of shareholders they have. (In a nutshell, S Corporation shareholders need to be either individual U.S. citizens or permanent residents or something that's closely connected with such an individual taxpayer such as a testamentary trust or an estate.) * An S Corporation may have only one class of stock. You can't, for example, have preferred stock and common stock. And you can't have shareholders' whose stock is treated differently. Note that you can have nonvoting stock. * S corporations also are required to use some nitpicky tax accounting rules that some other entities aren't subject to. This is pretty esoteric stuff, but to give you an idea, an S Corporation needs to use a fiscal, or accounting, year that ends the last day of September, October, November or December. And an S Corporation is limited in the number of shareholders they can have. (The limit on the number of shareholders is currently 100, but you can actually have more than 100 shareholders because some shareholders--like those in a family--are combined when you count shareholders in an S Corporation.) Subchapter S Corporation Facts Subchapter S Corporation Filing Requirements: Every corporation (except exempt) must file, regardless of the amount of income or loss. It must file even if it stops conducting business. Filing ends when totally dissolved. Subchapter S Corporation Filing Deadline: By the 15th day of the 3rd month following the close of its tax year. Subchapter S Corporation Extension Deadline & Form Number: Form 7004 automatically extends the deadline 6 months. A second extension is not available. Subchapter S Corporation Penalties: • $50 penalty per shareholder for Subchapter S corporation's failure to provide K-1's to the shareholders. • If Subchapter S corporation taxes are due, a late filing penalty may be imposed equal to 5% of tax owed per month up to 25%. • A late payment of tax penalty may also be imposed equal to one-half of 1% per month up to 25%. Letter Ruling 9627004: Unlike a partnership, the IRS Code does not impose a penalty for late filing of a Subchapter S corporation tax return. Penalties for late payment or late issuance of K-1s still apply. Subchapter S Corporation Tax Rates: S corporation profit or loss is passed through to shareholders and reported on the shareholders’ tax returns. A Subchapter S corporation generally does not pay tax at the corporate level. Exception: If the Subchapter S corporation was previously a C corporation, the Subchapter S corporation may be liable for tax on excess net passive income, certain capital gains, or built-in gains. Subchapter S Corporation Estimated Tax Requirements: Shareholders are responsible for payment of estimated tax on
Things work differently for the S corporation, however. To make calculations easy, assume the S corporation is owned by a single shareholder. In this case, the S corporation must break the $90,000 of profit into two buckets: wages and the leftover (which is called a distributive share). If the wages equal $40,000 and the leftover distributive share equals $50,000, the business pays Social Security and Medicare taxes (equivalent to self-employment tax) equal to roughly $6,000. In this case, even though the two businesses make the exact same amount of money, the S corporation pays roughly $7,000 less in tax each year. S Corporations also provide a couple of other benefits-benefits which are a little more difficult to quantify but still important nonetheless. One such benefit is that S corporation losses (such as those that often occur in the early startup years) can be used as tax deductions on the shareholders personal income tax returns. Another such benefit is that the S corporation isn't taxed on S corporation profits at least by the federal government. Costs and Drawbacks of an S Corporation: An Introduction An S Corporation suffers from some drawbacks and also cause business owners to incur extra costs. What follows below isn’t an exhaustive list of these drawbacks and costs, but it gives you a good starting point: * Bank account fees typically go up for corporate businesses, including the small S Corporation. While a sole proprietorship may bank for free, an S Corporation typically can't. (Check with your bank for more information about this.) * An extra tax return is required—and usually this tax return must be prepared by an enrolled agent, CPA or other tax professional. It's not uncommon to find yourself paying from several hundred to even a few thousand dollars more a year for your S Corporation tax returns.) * The new S Corporation must now file quarterly and annual payroll tax returns—even if the only employee is the owner. What's more, the new S Corporation will need to pay federal
their personal returns. The Subchapter S corporation must pay estimated tax payments if corporate level taxes apply. No Double Tax On Profits: A Subchapter S corporation conducts business as a corporation, but is taxed in the same manner as a partnership. A major advantage of a Subchapter S corporation is that income passed through to shareholders avoids the double taxation that occurs with a C corporation
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