LLC vs S-Corp
When to Make an S Corp Election vs. Remaining an LLC
Choosing the right business structure is a critical decision that can have significant tax implications. One of the most common considerations for small business owners is whether to remain an LLC or elect S Corporation (S Corp) status. Here’s a detailed look at the key differences and considerations to help you decide which is best for your business.
Key Differences Between an S Corp and an LLC
1. Payment of Reasonable Wages: One of the main distinctions between an S Corp and an LLC or sole proprietorship is the requirement for owners to be paid a reasonable wage. This wage sets the base at which employment taxes are paid. Employment taxes include FICA (15.3% split between employer and employee sides), FUTA, and SUTA. For LLCs and sole proprietorships, all net income is subject to self-employment tax.
2. Employment Taxes and Workers' Compensation: By paying yourself a reasonable wage in an S Corp, you can potentially save on employment taxes. In contrast, for LLCs without S Corp election, all profits are subject to self-employment taxes, including any bonus depreciation. Additionally, S Corp owners may save on workers’ compensation insurance if they decide to be covered.
3. Self-Employment Taxes on Bonus Depreciation: One often overlooked aspect is that bonus depreciation in an LLC without S Corp election is still subject to self-employment taxes. Electing S Corp status allows you to bypass this issue, as only the reasonable wage is subject to employment taxes, while the remaining profits are not.
What is Considered a Reasonable Wage?
The concept of a reasonable wage is crucial in determining how much employment tax you will pay. A reasonable wage is what you would pay someone to do the job you are doing. Here are the steps to determine and document a reasonable wage:
Research Salaries: Look up salary information from at least three different sources such as LinkedIn, Glassdoor, and other salary databases.
Localize the Data: Ensure the wage information is specific to your geographic area, as wages can vary significantly by location.
Document the Range: Compile the salary data to produce a range. It’s important to document these findings to support your wage decision in case of an audit.
Regular Updates: It’s best practice to review and update this wage every three years to reflect changes in the market and your role.
General Suggestion for Business Owners
Once your business is making more money than the reasonable wages by $10,000, it is generally a good idea to switch to an S Corp. It is also important to be mindful of deadlines. The deadline for filing the election form is 2 1/2 months after you create the business or by March 15 of the current tax year. For example, if you want to file the form for the 2025 tax year, you have until March 15, 2025. There is a late filing option, but there are requirements that must be met to file late.
Example of Potential Savings
Let's illustrate the potential savings with an example. Suppose an electrician starts a business and determines that a reasonable wage for an electrician is $70,000. The business makes $120,000 in total. The savings would be 15.3% of the difference between the total income and the reasonable wage.
Calculation:
Difference between total income and reasonable wage: $120,000 - $70,000 = $50,000
Savings on employment taxes: 15.3% of $50,000 = $7,650
Additionally, the electrician would save on workers’ compensation for the difference, since it is not considered salary. Assuming the workers’ compensation rate is $2.63 per $100:
Workers' Compensation Savings:
Rate per $100: $2.63
Difference in income: $50,000
Workers’ compensation savings: ($50,000 / 100) * $2.63 = $1,315
Total Savings:
Total savings (employment taxes + workers' compensation): $7,650 + $1,315 = $8,965
By switching to an S Corp and paying themselves a reasonable wage, the electrician would save approximately $8,965 in this scenario.
Conclusion
Deciding between an S Corp election and remaining an LLC involves weighing the benefits of tax savings against the administrative complexities. By understanding what constitutes a reasonable wage and the tax implications of each structure, you can make an informed decision that aligns with your financial goals. Regularly reviewing your wage and staying compliant with tax laws will help you maximize the benefits of your chosen business structure.