Question: I have a services-based business in the Seattle-Bellevue area with three employees. What type of entity should I adopt in order to minimize my tax obligations? S Corp, C Corp, or LLC? Right now, I am a sole proprietor. My previous tax accountant said I would save money as a limited liability company (LLC).
Owners of limited liability companies (LLCs) who are active in the company operations are generally subject to the same self-employment tax.
Your business can reduce its self-employment tax obligation by creating an S-corporation. S Corp profits are not subject to employment taxes. The owners’ wages, however, will be subject to employment taxes like any other employee.
Many S-corporation owners don’t pay wages to themselves for this reason. They take profit distributions only, thereby avoiding all employment taxes. These taxpayers are at risk of paying penalties if audited by the IRS. The IRS requires that S-corporation owners who operate their business pay themselves a “reasonable wage.”
Now you realize that you can maximize your tax savings by creating an S-corporation and paying yourself the smallest wage that qualifies as “reasonable.” So what is reasonable? The IRS does not give specific figures. Also, there is very little case law to provide guidance by example. There are numerous factors to determine a reasonable wage.
Courts would look at the work done by the owner compared to other persons performing similar duties. Courts will also look at the capital contribution by owners. If profits are attributable to capital investments rather than the owner’s efforts, then there needs to be a greater allocation of profit distribution. Also, if profits are attributable to the leverage offered by employees, rather than the owner’s professional services, then (again) there needs to be a greater allocation of profit distribution.
Assuming that $50,000 per year is a reasonable salary, you could save $9,451 in employment taxes by creating the S-corporation and paying yourself this wage from the $200,000 profit.
For some fast insights, visit our self-employed tax calculator page.
Frequently Asked Questions
What is the difference between C Corp and S Corp?
C corporations pay taxes on their income plus whatever income you receive as an owner of a company. Meanwhile, S Corp are more versatile in that you only need to report business income. This enables you to deduct up to 20% of your income.
S Corps tend to be scrutinized much more by the IRS whereas C Corps are effectively double taxation. C Corp tends to hurt smaller companies, making it less ideal. But because S Corp is more scrutinized, it’s worth working with a CPA to make sure you’re doing it right.
Why would you choose an S Corporation?
One of the main reasons to transition from a sole proprietorship to an S Corp is your personal assets are protected. Knock on wood, but if a client were to sue you as a sole proprietor, you could wind up losing a lot more than your business. By changing your entity to an S Corp, you keep your personal assets safe from litigation.
Is LLC or S Corp Better?
If you have more than one person running the company, then an S Corp would be ideal as everyone receives tax benefits, not to mention dividends: it’s a win/win. An LLC provides some protection from litigation and tend to be taxed better than a sole proprietorship (or C Corp), but the business practice is far more simple. In other words, the laws an LLC must abide by are much more loose whereas to qualify as an S Corp, there’s a few more terms and conditions.