Edit for clarification – By default, an LLC is treated for tax purposes as either a Sole Proprietorship (single owner LLC) or a Partnership (multiple owner LLC.) You can, however, elect to be treated as a corporation and then elect that corporate status to be S Corp. These are two separate elections and the IRS must approve your elections before they become effective. There are rules and deadlines to satisfy, so consult your tax professional.
The vast majority of LLC’s I see have not done the elections for S Corp status, and are therefore paying more in payroll taxes than necessary. Hence, the following article.
If your business is organized as an LLC, you have a choice of being taxed as a Corporation or as a Partnership. Most LLC’s choose the latter through inaction.
If this is you, you’re wasting money on FICA taxes. All of the Guaranteed Member Payments and the net income for those actively engaged in managing the business are subject to FICA (Social Security and Medicare taxes.)
The profits of an S Corporation are NOT subject to FICA. Here’s how the two compare:
For simplicity, let’s assume you are the sole owner of your LLC and you actively manage the business. The income to you (Guaranteed Payments and/or net income in any ratio) is $80,000. The entire $80,000 will be subject to the FICA self employment tax of 15.3% for a total of $12,240. Half of this will be deductible from your income tax – worth approximately $1,836 in the 30% tax bracket, for a net cost of $10,404.
An S Corp is Treated Differently
Salaries paid to an owner of an S Corporation are subject to FICA – the company pays half and the employee (owner) pays half. The total is still 15.3%.
Here’s where it gets interesting. The profits of the S Corp are NOT subject to FICA. Let’s see how our example changes.
Let’s assume the same $80,000 in income, but this time half ($40,000) is paid as salary and half is allowed to flow through to the owner as profit. Both halves of the FICA total $6,120 – half of the total for the LLC. The half paid by the corporation ends up being a tax deductible expense, so at the same 30% income tax bracket, this is worth $918. The resulting total is $5,202 – a savings of over $5,000.
Don’t Get Greedy
You are probably thinking that if splitting your income 50/50 between salary and profits is good, splitting 80/20 or 90/10 must be even better.
All things being equal that would be the case, but the IRS knows this too. There are rules in place that require your salary to be "reasonable." What’s reasonable is subject to interpretation, so you should consult your tax advisor.
You May Still Want an LLC
There could be some other reasons why you want an LLC, even though it costs extra FICA taxes. You should consult your attorney or CPA. However, for most business owners I believe an S Corporation is the way to go.