Although many new business owners who will actively participate, ie. who do "materially participate," in their businesses choose to organize limited liability companies (LLCs) as opposed to incorporating S-Corporations because of, among other things, greater flexibility and the lack of state-required reporting formalities, there is at least one potentially compelling reason to incorporate an S-Corporation, or at least elect taxation as an S-Corporation under Subchapter S of the Internal Revenue Code (IRC): potentially lower employment taxes.
If a business owner actively participates in a business, such owner is subject to Federal Self-Employment Tax (SE Tax). In 2013, SE Tax is imposed on the first $113,700 of combined wages, tips, and net earnings which are earned by such a business owner, commonly called earned income.
While shareholders of S-Corporations are required to pay SE Tax on earned income they receive for the services they provide to the S-Corporation, they are not required to pay SE Tax on distributions of profits.
By default an LLC is taxed as either a disregarded entity, in the case of a single-member LLC, or a partnership under Subchapter K, in the case of a multi-member LLC. In either case, however, the IRS will chracterize the first $113,700 (as of 2013) of income received by an LLC member as earned income, which is subject to SE Tax.
An LLC may, however, elect taxation as an S-Corporation under Subchapter S, as discussed below.
Why Does This Matter?
As of 2013, the SE Tax rate, which consists of both the employee and employer shares Social Security & Medicare taxes, is 15.3%. As such, the potential payroll tax savings on $113,700 (as of 2013), could be substantial.
For example, Business A is a brick and mortar cupcake shop. While the owners of Business A are actively involved in the business, they only spend about 10 hours per week managing the business and employees do the rest. If Business A is an LLC taxed as a partnership under Subchapter K, the distributions of profits, i.e. non-earned income payments, made to the owners, up to $113,700 (as of 2013), will be subject to SE Tax even though such distributions are not attributable to services provided by the owners. However, if Business A is an S-Corporation or an LLC taxed as an S-Corporation under Subchapter S, the distributions of profits made to the shareholders are not subject to payroll taxes by default; rather, only the income earned by the owners, i.e. wages, salary, and compensation for services provided by the owners, is subject to payroll taxes.
Changing the Presumption
An LLC can elect to be taxed as an S-Corporation as opposed to a disregarded entity or partnership in order to eliminate the presumption regarding earned income. However, such an election comes at the cost of flexibility and convenience; among other things, because Subchapter S of the IRC imposes more restrictions than those imposed upon disregarded entities or partnerships. Some of the most notable restrictions are as follows:
- S-Corporations may not have more than 100 shareholders;
- S-Corporation shareholders must be US citizens/residents;
- S-Corporation shareholders cannot be C-Corporations, other S-Corporations, LLCs, partnerships, or certain types of trusts; and
- S-Corporations may only have one class of stock.
In order to elect taxation under Subchapter S, an LLC can request a Federal Tax ID (EIN) and file Form 2553 with the IRS (and Form 8832, if necessary).
This brief overview of some important considerations associated with LLCs, S-Corporations, and earned income is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
Douglas K. Cook is an attorney with over 40 years of experience. Although Cook & Cook's office is located in Mesa, Arizona, the attorneys at Cook & Cook represent clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.