When starting a new business, many entrepreneurs elect to structure their new business as a limited liability company (LLC). The LLC structure can protect owners from personal liability for their business operations (unlike many sole proprietorships and partnerships) and are relatively easy to form and operate (as compared to corporations, which are subject to various statutory requirements). Unfortunately, many new business owners fail to consider the tax implications of forming an LLC and are surprised to learn that the Internal Revenue Service (IRS) does not recognize LLCs for purposes of taxation.
By default, the IRS treats all LLCs as if they are sole proprietorships (for single-member LLCs) or partnerships (for multi-member LLCs). Income generated from the business passes through to the business owner, and a self-employment tax is assessed against 100% of the business profits, including all compensation paid to the owner. Under the default taxation regime, the IRS does not distinguish between compensation paid to an owner of an LLC as a return on investment and compensation paid to an owner that is also functioning as a full-time employee of the business.
As an alternative to the default tax regime, an LLC may file an election with the IRS to be taxed as an S Corporation (S Corp). Income generated by an LLC that has elected S Corp treatment also passes through to the business owner, however, owners may avoid the self-employment tax. Unlike the default regime, an S Corp owner who performs services for the LLC may wear two hats – that of the business owner and that of a business employee.
As an owner-employee of an S Corp, the owner-employee will be required to pay social security and Medicare taxes (customarily referred to as “payroll taxes”), and the LLC will be required to withhold federal income and employment tax from the employee. However, so long as the owner-employee is paid a reasonable salary, all additional distributions to the owner-employee will be treated as dividends and will not be subject to payroll taxes. Further, because the owner is viewed as being employed by the LLC, the business will avoid the imposition of the self-employment tax.
For example, if an LLC generates $500,000 of income, under the default tax regime, the LLC will be subject to a self-employment tax assessment of approximately $75,000. Under the S Corp tax regime, assuming the LLC pays its owner-employee a reasonable salary of $100,000, then the LLC would only pay approximately $15,000 in payroll taxes.
This example shows a substantial tax saving to the LLC. However, it is important to note that the LLC profits in the S Corp example will still be treated as passing through to the owner, who will then claim the profits as personal income. So, although the LLC sees savings at the business level, it is important that the owner have a thoughtful tax plan in place that takes advantage of all available income tax deductions.
Before making any decision regarding the best tax strategy for you and your LLC, please seek professional advice from an experienced accountant and corporate attorney. These professionals routinely work together to ensure that your tax planning needs are being addressed in a way that minimizes your overall tax liabilities while preserving the legal integrity of your business.
The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content, and materials are for general informational purposes only.
