Do you have a successful business? Now that you have survived another April 15 (or 18) tax filing, it is time to start planning ahead to reduce your tax liability. Read on for more about a tax break next year.
If you formed your business as a limited liability company because of its simplicity, ease of administration–fewer filings, fewer forms, fewer start-up costs, fewer formal meetings and record keeping requirements than a corporation– you can still reap the benefits of electing to be taxed as a Subchapter S corporation for federal income tax purposes.
Tax Break /Form 8832
How is this possible? It’s all because an LLC does not have its own tax scheme. Rather the IRS allows an LLC to “check the box” on tax Form 8832 and choose to be taxed (depending on the number of members) as a disregarded entity, a partnership or a corporation.
If the LLC elects to be taxed as a corporation, the LLC may then elect to be treated as a S corporation by the IRS for tax purposes. The LLC will have to make a special election with the IRS using Form 2553. It’s no more difficult that setting up a corporation and then electing S corporation status.
S Corporation Offers Tax Break
So, why is there a tax savings to an LLC that elects to be taxed as a Subchapter S Corporation? When you are taxed as a sole proprietor or as a partnership, all net income is passed through to the member(s) as income and reported on the individual member’s personal tax return and it is all counted for the purposes of the federal self-employment tax at a rate of 15.3%. It is the equivalent of the FICA and Medicare tax which is deducted from your pay if you are paid via payroll and it includes both the employee’s share and the employer ‘s share.
A key feature of the S corporation is its ability to minimize overall tax liability for you and your business. Because of its nature as a corporation, only the wages paid to its owner/employees are earned income subject to FICA tax for Social Security and Medicare. If your company is successful enough, you can split member’s compensation into two parts: pay a salary via payroll that is “reasonable” for a company that size and type and then pay another amount – distribution of “profit”-directly to the member. This would be analogous to a dividend and that distribution is not subject to the self- employment tax. Furthermore, it is not subject to the New Hampshire Interest and Dividend tax. The best of both worlds!
For example, Bob and Joyce have a profitable business which they have been operating as a general partnership. The company is taxed as a partnership and has a profit of $220,000 which is allocated to Ted and Sally equally. Ted and Sally report this on their individual 1040’s and, in addition to whatever federal income tax they owe, each pays 15.3% as self-employment tax. 15.3% of $110,000 is $16,830 each or $33,660 combined.
Bob and Joyce form an LLC to operate their business. They elect to have the LLC taxed as a Subchapter S corporation. Each take $50,000 in salary (an amount that is reasonable based upon market rates for their role in the company) and have income tax and FICA/Medicare taxes withheld. The company then distributes $55,000 to each as their share of the profits. Obviously, this amount along with their salary is added to their gross income for income tax purposes but the $55,000 is not subject to the self-employment tax so each save 15.3% of $55,000 or $8,415 each getting a tax break of $16,830 combined per year. A significant tax savings that results in a significant increase in take-home compensation available for both of the members (owners) of the business.
Tax Break Benefits
And, if you are asking yourself, “why shouldn’t one just form a corporation and elect to be taxed as an S corporation rather than forming an LLC and filing two forms with the IRS?” you should consider the added benefits to forming an LLC and electing to be taxed as a S Corp. Some of the tax break benefits are:
- From a legal standpoint, your enterprise will be an LLC rather than a corporation. Therefore, you will have the benefit of ease of administration–fewer filings, fewer forms, fewer start-up costs, fewer formal meetings and record keeping requirements. Those formal requirements for a corporation can become burdensome and tricky for a small business. And, if the formalities are not followed, the owners are opening up the possibility that a third party may be able to “pierce the corporate veil” and subject the owner’s personal assets to potential liability for the debts and liabilities of the company.
- From a tax perspective, your enterprise will be treated as an S corporation. You’ll still have the pass-through of income, avoiding double taxation, same as if your LLC was treated as a proprietorship or partnership.
- Without the administrative hassles of actually being a corporation, you will still benefit from the IRS treating your business as one. To the IRS, your business will exist separate and independent from you–its owner. And, as discussed above the primary benefit of that is that the business can pay the owners wages or a salary. The amount of the wages or salary will be subject to FICA tax and other withholding requirements – just as any other employee of the company. But, as discussed above, that salary needs only to be reasonable compensation. Other earnings of the company may be distributed to the members of the LLC as passive dividend income which is not subject to the self-employment tax.
But setting up an LLC and then electing treatment as an S corporation may just give you the best of both worlds–the ease of administration of the LLC and the tax planning opportunities of the S corporation.
Note: all is not lost if you are incorporated rather than organized as an LLC. We can help you convert to an LLC