On Monday, I discussed the basic business formations for a person going out on his or her own. I recommended a single-member LLC for most people who start out by themselves because of the less burdensome formation and administrative procedures, as opposed to those for an S-Corp.

Unfortunately, those that choose the single-member LLC may miss out on the tax advantages of the S-Corp. Meaning, they don’t get to avoid paying self-employment on those profits earned over their reasonable salary.

What if there was a way to enjoy the benefits of easy administration and still take advantage of the tax savings offered by an S-Corp?

Well, you can when you elect to have your LLC taxed as an S-Corp.

The Normal Tax Structure

As a reminder, the single-member LLC is normally disregarded for tax purpose, and the owner of the LLC files the business’ profit and loss on his or her schedule C, like all sole proprietors.  The member has to pay self-employment tax (i.e., the social security and Medicare tax) on all net business income.  That’s an additional 15.3% tax on income earned.  (Although you get to take an adjustment for half of that on your tax return as well.)

S-Corps, on the other hand, have to file an 1120S. This form is the business’ income tax return. Any profit or loss passes through to the sole-shareholder on the Form K-1, and the shareholder claims the profit or loss on his or her schedule E. As long as that shareholder takes a reasonable salary (a fact based determination), all other profit avoids self-employment tax.

The Reasonable Salary Requirement and How You Benefit From S-Corp Taxation

The “reasonable salary” requirement is key here because the Government still wants to get its 15.3% on a good amount of your income. In other words, you are still paying 15.3% in FICA tax (half as the owner of the business and half as an employee) on what would be required from similarly-situated employees. If you try to get away with not paying any of that tax and get caught, you’re subject to substantial penalties.

The huge advantage comes if your business profits significantly over your reasonable salary. Say you’re a CPA running your own accounting firm, and your experience and expertise commands an $85,000 yearly salary. If your business earns you $85,000, you are no better off than if you had filed a Schedule C. (You still pay 15.3% on $85,000.)

However, if your business nets $200,000, you’ve just gotten away with avoiding having to pay 15.3% on $125,000.  That’s a savings of $19,125 in tax!  

The bottom line is that this type of status only benefits you if your business profits significantly over your reasonable salary, but that savings can be substantial in the long run.

Have Both Ease of Administration and Tax Savings

The prospect of a huge tax savings may intrigue you to pursue taking the plunge and establishing your business as an S-Corp. Yet all the formalities – board members, shareholder meetings, meeting minutes – probably make you wonder whether the tax saving will be worth the hassle. Luckily you can get the benefit of tax savings without the administrative hassle.

You can establish your business as an LLC and make an election on Form 2553 to be treated as an S-Corp for tax purposes.  You have to pay yourself a reasonable wage, which means 941/943 and 940 filing requirements, plus a W2 and K-1 at the end of the year. But you get the benefit of avoiding self-employment tax on any profit above that wage. Additionally, for business purposes, you still function as an LLC: so fewer filings, no meetings, and fewer record keeping requirements.

The other beautiful thing is that you don’t need to make the election right away. You can make it anytime after you form the LLC. However, you have to make the election:

• No more than two months and 15 days after the beginning of the tax year the election is to take effect, or
• At any time during the tax year proceeding the tax year the election is to take effect.

You should also keep in mind that once you make the election, you can’t switch it for 60 months, unless you get the IRS’ permission.

So it may be smarter to keep the default “disregarded entity status” while the business is starting up (and probably not making a profit) and then elect the S-Corp status once the business takes off.

Establishing an LLC and electing S-Corp taxation status is the epitome of having your cake and eating it too. You still have to take into consideration the quirks of your business structure, goals, and income, but it could be a way to really benefit by taking advantage of the positive aspects of both entities.