I have a friend that is starting a business and they asked for my advice on the most tax-efficient way to set it up (i.e. how to pay the least amount of taxes possible).
After some discussion about what the business is and how much they expect to make, we landed on establishing a Limited Liability Company (LLC) and to elect filing taxes as an S-corporation. In short, here’s why.
Key points:
- S Corporations have some tax planning unavailable to your run-of-the-mill LLC. The FICA tax for Social Security and Medicare (also known as self-employment taxes) only applies to wages paid to owner-employees. The remainder of the net earnings passes through as dividend income.
- S-Corps avoid double taxation by reporting the gains and losses on the shareholders’ individual tax returns.
- For tax years 2018-2025, a deduction equal to 20% of the share of an S-corporation’s profit can be claimed, subject to limitations.
Self-employment tax savings
Technically, S-corporation status is a federal tax status, while an LLC is a type of legal entity created under state corporate law.
LLCs almost always stick with the default tax rules, under which they are treated either as a sole proprietorship or a partnership, depending upon the number of owners. As your income from your LLC increases, so does the self-employment tax. You earn more, you pay more tax.
An S-Corp lets you split your profits into “shareholder wages” (subject to 15.3% Social Security, Medicare, and self-employment taxes) and “distributive share” (NOT subject to 15.3% Social Security, Medicare, and self-employment taxes).
An owner of an LLC with pass-through taxation pays 15.3% on the entire profits. Active owners in an S-Corp must pay themselves a reasonable salary (more on this down below), but realize a 15.3% savings on the rest of their retained profits.
avoid double taxation
Usually, corporations are taxed as its own entity. The corporation files IRS Form 1120 each year to report its income, deductions, and credits, and profits are typically taxed at corporate income tax rates.
That’s pretty cut and dry, but where small business owners can run into trouble is through something called double taxation. That’s because when the corporation distributes dividends to the stockholders (the business owner), these dividends are taxed on their personal tax returns.
If you’re a small business owner and expect to put some of the profit into your own wallet, the money could end up being taxed twice: first, the corporate profits are taxed at the corporate level and then the distributions are taxed on an individual level.
When filing as an S Corporation, the company itself no longer pays taxes on the profits. Instead, any profit or loss is passed to the owner and they report it on their personal tax return.
QBI deduction
In 2017, the Tax Cuts and Jobs Act established IRS Code Section 199A, which provides a 20 percent deduction for eligible pass-through entities with qualifying business income (“QBI”). This new provision has the ability to reduce the maximum individual tax rate of 37% on pass-through income to approximately 29.6%, making it more equitable to the C corporation tax rate of 21%.
The QBI offers a way to lower the effective tax rate on the profits of owners of pass-through entities. These include sole proprietorships (including independent contractors), partnerships, limited liability companies, and S corporations.
Salary amount
As the owner of an S Corp, you take a salary and only this portion is subject to FICA and Medicare taxes. Any remaining profit that is distributed is treated as a dividend and taxed as ordinary income, but not subject to payroll taxes.
Obviously, this creates an incentive for owners who work for an S-corporation to pay themselves the least amount possible. The IRS is aware of this incentive and requires shareholders to pay themselves a reasonable salary.
What is considered a reasonable salary depends on the net income and industry, so it is difficult to give a target dollar figure. You may hear the general rule of that salary can be two-thirds of net income. However, take this with a grain of salt. The salary number is very subjective relative to industry standards and should be supportable.
It’s advisable to work with a Certified Public Accountant to determine how much is a reasonable salary for the field you are in.