by Eric Felton

When starting a business, determining the entity type that is right for you is one of the most important decisions an owner will have to make. LLCs or partnerships have been a popular choice of entity types for quite some time, but depending on your circumstances, an S corporation may be a better option.

A popular reason not to consider an S corporation is the requirement that all profits not paid as salary must be distributed exactly in accordance with ownership percentages. An LLC taxed as a partnership offers much more flexibility in allocating profits and distributions. However, S corporations also have substantial advantages, as we discuss below.

Pass-Through Taxation

In a traditional corporation, all net income earned by the corporation, after the payment of all salaries and bonus payments, is taxed at the corporate level at a rate of 21% . This same income is taxed again at the individual level when the shareholder receives distributions in the form of dividends. Depending on the individual’s Adjusted Gross Income, the tax on these dividends can be as high as 23.8% , plus state taxes. However, in an S corporation, all income is passed through to the shareholders and taxed at the individual level rather than being subject to the double taxation mentioned above. The income reported on the individual level is taxed once as ordinary income at rates of 10 to 37% depending on the individual’s taxable income.

Self-employment Tax Savings

Another advantage of an S corporation is the potential for self-employment tax savings. As a member of an LLC, your share of income from the partnership is subject to self-employment taxes (employer and employee portion of FICA tax). As an S corporation shareholder, you only pay FICA tax on your wages and the remaining profits from the company are not subject to self-employment tax. Depending on the income of your business, this could lead to substantial savings. The IRS requires S corporation shareholders to take reasonable compensation in wages to avoid abuse. To illustrate the potential tax savings of this strategy, here is an example:

Ashley forms a single-member LLC for her IT support business and elects to be taxed as an S corporation. For the tax year, the S corporation had net income of $250,000. Since the corporation must pay Ashley reasonable compensation for working within the business, she determines reasonable compensation to be $100,000. After paying these wages, the net income of the business is reduced to $150,000. Ashley and the business will pay FICA taxes on her wages of $100,000, totaling $15,300. The $150,000 of net income will pass through to Ashley and will not be subject to self-employment taxes. If Ashley had not elected S corporation status, the full $250,000 would be subject to self-employment taxes. 

Qualified Business Income Tax Deductions

With the implementation of the Tax Cuts and Jobs Act (TCJA), there came another tax advantage for certain S corporations. TCJA brought us a new deduction of up to 20% of the taxpayers’ Qualified Business Income (QBI) from pass-through entities. For high-income taxpayers, this deduction requires the business to either pay wages or have large amounts of tangible assets.

As an LLC member, you can’t pay yourself a salary. Many LLC members receive guaranteed payments, but these are not considered QBI. Depending on your business, many LLC’s will not generate enough wages to allow a 20% QBI deduction on your personal return.

S corporation shareholders, can take a salary that creates wages for purposes of calculating the QBI deduction. This is an area where we have worked with a number of our clients in analyzing the potential tax savings of converting from an LLC to an S corporation.

How to make an S Election

Electing to be treated as an S corporation requires the filing of Form 2553. This form needs to be filed no later than 75 days after the beginning of the tax year in which you wish to make the election. For example, if you would like to be taxed as an S corporation for the 2020 tax year, you need to file Form 2553 before March 15, 2020.

As with any IRS related issue, there are many additional considerations that would need to be discussed before switching an entity type. We would be happy to talk to you about these issues at any time.