Choosing between an LLC and an S Corporation: Self –Employment Taxes can Tip the Balance

I am a member of a Business Networking International Association Chapter (BNI) in Northwest Arkansas and this past Wednesday I gave a presentation on Business Law Strategies (The things a prospective business owner should pay attention to when being in ownership position). At the conclusion of my presentation, a highly intelligent lady asked me a question, and I was not able to fully answer it due to time. However, I would like to address the question here. The question read “What would you say we, self-employed people, should pay attention to when deciding whether to incorporate at all?”

In deciding whether to incorporate you should pay attention to which form of incorporation will save your business the most money. A big incentive for creating a corporation versus an LLC is saving money through self-employment taxes. As a business owner saving money should be one of your priorities because just like the market has a tendency to fluctuate so does your business. In my humble opinion, an S corporation is better than a single member LLC, as explained in the following paragraphs.

You know that taxes are withheld from employees’ paychecks. In 2015, for example, employers withheld 7.65% of the first $118,500 of an employee’s pay for Social Security and Medicare taxes, and 1.45% of earnings above the amount for Medicare taxes. The employer adds an equal amount (to match the employee’s share of Social Security and Medicare taxes) and send these funds to the IRS. The total sent to the IRS is 15.3% on the first $118,500 of wages and 2.9% on earnings above that amount.

You may not be aware that the IRS collects a similar 15.3% tax on the first $118,500 earned by a self-employed person and a 2.9% tax on earnings above that amount for Medicare alone. For this reason, the Social Security and Medicare tax is often referred to as the “self-employment” tax.

In 2015, there was Medicare surtax of 0.9% on the wages and self-employment income of high earners. This surtax applied when a single person’s earnings exceeded $250,000. On earnings above those amounts, the Medicare tax rate becomes 3.8% rather than 2.9%. This surtax did not affect the 1.45% rate paid by an employer.

For an S corporation, the rules on the self-employment tax are well established: As an S corporation shareholder, you pay the self-employment tax on money you receive as compensation for services – but not on profits that automatically pass through to you as a shareholder. For example, if your total share of S corporation income is $100,000 in 2015 and you perform services for the corporation reasonably worth $65,000, you will be taxed 15.3% on the $65,000 by not on the remaining $35,000.

If you have a single-member LLC, you’ll owe self-employment tax on 100% of your company’s profits. The rules for multimember LLCs are more complicated, and, for now, somewhat unsettled. Proposed IRS regulations (which Congress had placed on hold) would impose the self-employment tax on your entire share of LLC profits in any of the following situations:

  • You participated in the business for more than 500 hours during the LLC’s tax year.
  • You work in an LLC that provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting (no matter how many hours you work).
  • You’re empowered to sign contracts on behalf of your LLC.

Even though these proposed regulations do not have the force of law, the IRS says it won’t challenge you if you use them in determining your liability for self-employment tax. This means that if you don’t fall into one of the three categories listed above, you can use the same rules that apply to S corporation shareholders. But if you do fall into one of the above categories, you should assume that 100% of your income from the business will be subject to self-employment tax.

The point is that, in some cases, an S corporation shareholder may pay less self-employment tax than some LLC members with similar income. You’ll need to decide whether these potential tax savings are more important than gaining such LLC advantages as flexibility in management structure and in distributing profits and losses as mentioned during my presentation.