1. LLC vs. S Corporation
2. How are LLCs and S Corps Taxed?
3. S Corp vs. LLC: Tax Benefits

LLC or S corp. tax advantages include the option of having the business income taxed on behalf of individual owners instead of the company.

LLC vs. S Corporation

New businesses should start out as an LLC. An LLC can choose S corp. status, but it's not possible to convert an S corp. to an LLC.

It's hardly sensible to convert a single-owner business into an S corp. for tax benefits. If the business' income is primarily made through sale of products, then structuring it as an S corp. might be beneficial. However, if the business' primary income is from the services provided by an individual, there is hardly any tax benefit in forming the company as an S corp.

An LLC is a separate legal entity from its owners, known as members. An LLC can have one or more members. The LLC structure is suited for small businesses and offers more flexibility than corporations. There are fewer formalities and legal obligations in terms of reporting and recordkeeping.

An S corporation is not a form of business. It only refers to special taxation status granted by the IRS. Though most of the single-member LLCs qualify for S corp. election, it must meet certain conditions. A business entity can't opt for S corp. status if:

  • It's a foreign company.
  • Any of the owners are nonresident aliens.
  • Any of the owners are a corporation or a partnership firm.

You should elect the S corp. status only if it saves you money. Find out how much salary you would earn if you were to perform the same tasks in the capacity of an employee.

The salary you determine for owner-shareholders must pass IRS scrutiny. Once you've calculated the salary, ask yourself whether there would be any business profit left after deducting it. If there would be no profits, you wouldn't benefit from structuring your business as an S corp.

You can only save money through S corp. election if the business profits are higher than your salary. However, remember that your tax return would be little more complicated. If there are no other employees in the company, you must comply with the tax withholding requirements.

How are LLCs and S Corps Taxed?

For all businesses, tax is calculated based on the company's net income, which is computed by deducting all the allowable expenses from the gross income. Tax on an LLC's business income is paid by the owners individually on the basis of their ownership percentage.

For an S corporation, any profit remaining after deducting the working owners' salary is passed to individual owners for tax purposes. For example, if you own 50 percent of the company and receive a salary of $40,000, and the company makes a net profit of $60,000 (after deducting your salary), then you must include your salary of $40,000 and your profit share of $30,000 in your personal tax return.

S Corp vs. LLC: Tax Benefits

There is no separate federal tax classification for LLCs. Therefore, they are taxed either as a sole proprietorship, a partnership firm, a C corp., or an S corp. By default, a single-owner LLC is taxed as a sole proprietorship and a multi-owner LLC is taxed as a partnership firm. However, an LLC can opt to be treated as a C corp. or an S corp. for the purpose of taxation.

The major difference between taxation as a sole proprietorship, an LLC, and an S corp is the way you pay self-employment taxes (Medicare and social security taxes). Choosing S corp. status can help you save on these taxes.

An LLC owner reports the company's income and expenditure in his individual income tax return. He is considered self-employed and is required to pay self-employment taxes on the profits.

Just like self-employed individuals, employees are also subject to Medicare and social security taxes. However, half of the taxes owed by employees are paid by their employer.

An owner can be considered an employee if he is being paid a reasonable salary. The LLC gets to deduct the salary as business expenditure, and the owner-employee must include it as an income item in his personal tax return. Unlike sole proprietorships and LLCs, S corps pay Medicare and social security taxes only on owner-employee's salary.

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