S Corporations and LLCs provide the same liability protection!
Ignore gurus that say either an S corp or LLC is better. Your situation is unique. For limiting your liability and protecting your assets, both an LLC and an S corp give you the same level of protection. Just remember to maintain the formalities (as noted last week).
Ignore the marketing and urban myth that it is better to establish in a particular state, such as Delaware, Nevada, Wyoming, etc.. Those states offer no additional liability or asset protection. Plus, if you are not located in that state you now have to register and pay additional fees for the ‘foreign’ business to operate where you are conducting business. Remember the KISS principle.
So which should you use?
LLCs are better if the primary purpose is holding rental property or better documentation and operation of a partnership. Limited Partnerships have other specific benefits we’ll address in a later post. If you operate an S corp and want to create a new venture, product or brand but don’t want to complicate your taxes, a single member LLC owned by the S corp is an ideal way to establish a separate entity for the business without requiring a separate tax return. LLCs are your default if any of the owners of the business are corporations, not US Citizens or legal permanent residents including foreign owners, or otherwise do not qualify for the S election.
A corporation can elect tax treatment as a partnership by filing the Subchapter S election (IRS Form 2553) and then becomes an S corporation. This avoids the ‘double taxation’ of a “C” corporation – first paying taxes on net income at the corporate rate and then shareholders pay capital gains tax on remaining profits received as dividends. An LLC may elect to be treated as a corporation or a partnership (S election) for tax purposes. So both seem to offer the same tax benefits. However, there is one tax aspect often overlooked, Self Employment tax.
The Self-Employment Tax Trap
If you ever received a pay check you know the taxes deducted – currently 6.2% for Social Security & 1.45% for Medicare. These amounts represent 50% of those taxes paid by you. The employer pays the remaining 50%. When self-employed you are responsible for the entire 15.3% (12.4% SS & 2.9% Medicare) tax. This SE tax applies to ordinary net income of sole proprietors and LLC owners as well! Ordinary income is income from the sale of products, services, commissions and short-term real estate income (attention AirBnBers). If you have a profit after deducting your operating expenses the SE tax applies to the entire amount.
An S corp can significantly reduce the amount subject to the 15.3% SE tax. For an LLC all net operating income is subject to SE tax. With an S corp the owners can take a ‘reasonable’ salary (W-2) while protecting a significant portion of net income from SE tax by reporting it profits through the Schedule K-1. You only pay SE tax on the amount of your salary (W-2). ‘Pigs get fat, hogs get slaughtered.’ You must take some salary if you are profitable. Don’t abuse this or the IRS may visit!
You want your salary as low as possible to limit SE taxes but it must be reasonable. There is no hard and fast rule. A common rule of thumb is pay yourself about one third of the profits as salary, protecting 2/3 of the profits from SE tax. The percentage should change based on the total net operating income. If you are only making $20,000 net income, a reasonable salary may be $10,000 (50%). If your net operating income is $100,000, then a $10,000 is probably unreasonable – a 30 – 40% allocation may be more reasonable. If you’re killing it netting $300,000 or more in net operating income, a lower percentage 10-25% is probably reasonable.
Important: Consult with a CPA or accountant to determine the appropriate wage level for your situation!
What if I haven’t taken a salary for 2017?
It’s not too late! You should immediately consult with your CPA or accountant. There is still time to pay yourself a salary and pay applicable SE taxes over the next two months.
If you are just starting out you should seek sage legal and business advice NOW!
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Until then, Keep it Legit!