Outside of personal liability protection, one of the primary advantages of setting your business up as a Limited Liability Company (LLC) is flexibility in how your company is taxed. And many business owners elect to have their LLC taxed as an S Corporation (S-Corp) to save money on payroll taxes.
By choosing to be taxed as an S Corporation, you only pay payroll taxes on your salary, not on your profit distributions from the company, so you would save roughly 15% in payroll taxes on distributions taken as profits. Conversely, if your LLC is taxed as a sole proprietorship or partnership, all profits are subject to payroll taxes.
However, before you decide to have your LLC taxed as an S Corporation, you should understand the different requirements for such an election. One requirement is you must pay all owners of the company “reasonable compensation,” according to the IRS’s standards. Before we discuss what constitutes reasonable compensation, let’s first look at what it means to become an S Corporation.
What Is An S Corporation?
An S Corporation is not a business entity in and of itself. Rather, the S Corporation designation is simply a special tax election made by a corporation or an LLC. Unless you elect for your LLC to be taxed as an S Corporation, single-member LLCs are automatically taxed as sole proprietorships, while multiple-member LLCs are taxed as partnerships.
C Corporations also have the option to elect to be taxed as an S Corporation or as a C corporation. If you are set up as a C corporation and don't elect to be taxed as an S Corporation, the corporation pays taxes at the new flat corporate tax rate of 21% established by the Tax Cuts and Jobs Act. Then, after-tax profits are distributed to the shareholders, and those profits are taxed at the personal rate of each of the shareholders.
This system of “double taxation” means the corporation first pays tax at its rate, and then the shareholders pay tax at their own individual tax rates. To avoid this, some C Corporations elect to be taxed as an S Corporation. However, due to the expense and complexity of creating and maintaining a traditional corporation, very few small or mid-sized businesses are set up as C corporations.
If your LLC is taxed as a sole proprietorship or partnership, you will pay payroll taxes (FICA) and income taxes (state, if applicable, and federal) on all income earned by the business, less deductions. That means all income earned by you via a 1099 or paid to your LLC is reported on Schedule C of your personal tax return. After expenses are deducted, all of the remaining income is subject to payroll taxes (FICA taxes are 15.3%) as well as income taxes.
This is why many business owners who have LLCs and don’t elect to be taxed as an S Corporation often find themselves surprised by a big tax bill that doesn’t seem to make sense, given their total earnings. After you elect to be taxed as an S Corporation, you will file Form 1120-S with the IRS on behalf of the corporation, reporting all income and expenses on that return. But the corporate entity itself will not pay taxes. Instead, the business will issue you a K-1, indicating the net profit of the business, which will be reported and taxed as ordinary income on your personal return at your personal income tax rate.
And you will only pay the 15.3% FICA taxes on the amount paid to you as a salary via payroll, but you will not have to pay the 15.3% on the rest of the money you take out of the business in the form of profit distributions. In addition, the audit risk for S Corporations that file their own returns is typically less than the audit risk for companies taxed as sole proprietorships, where income and expenses are reported on your personal Schedule C.
Qualifications for S Corporation Election
Not all LLCs can elect S Corporation status. In order to file for the S Corporation tax election, your business must meet the following requirements:
Must be filed as a U.S. corporation
Can maintain only one class of stock
Limited to 100 shareholders or less
Shareholders must be individuals, estates, or certain qualified trusts
Each shareholder must be a US Citizen or permanent resident alien with a valid Social Security Number
All shareholders must consent in writing to the S Corporation election
Note: In addition to these requirements, for an S Corporation election to make sense financially, you’ll want to have at least $60,000 or so of net income per year.
To prevent business owners from avoiding payroll taxes by taking disproportionately large profit distributions, the IRS requires S Corporation owners to pay themselves “reasonable compensation” in exchange for their services. What constitutes reasonable compensation, however, is a highly subjective matter that has created an intense debate among business owners and tax authorities.
Indeed, the CPA Journal contends that “[t]he contested subject of reasonableness of compensation is one of the most frequently debated issues between business taxpayers and the IRS.”
If the IRS were to determine that an owner’s compensation was unreasonable, it could reclassify S Corporation profit distribution payments as wage payments subject to payroll taxes (FICA), which could leave you on the hook for a massive back tax bill. On top of that, you could face massive tax penalties, as well as negligence penalties, from the IRS.
What Is Reasonable?
Although you should consult with your tax advisor to ensure you’re paying yourself an appropriate amount, here are a few basic guidelines to follow.
The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” Obviously, that definition doesn’t provide much guidance and is extremely vague. Basically, the IRS is saying that your company’s owners should be paid what other businesses in your industry pay for similar services.
In determining reasonableness, the IRS looks at the company’s gross receipts and at the tasks the owner performed to help generate the company’s gross income. Additionally, the IRS takes the following factors into consideration to determine reasonable compensation:
Volume of business handled
Character of the job and amount of responsibility
Complexities of the business
Time required to do the job
Cost of living in the area
The use of a formula for determining compensation
Ability and achievements of the individual performing the service
Amounts paid out as salary compared with the amount distributed as profits
Company policy regarding wages for all employees
History of salaries for each employee
One helpful resource is the U.S. Department of Labor’s Bureau of Labor Statistics, which provides detailed wage data for more than 800 occupations with comparable wages by state, region, and city. You can also check out employer-review sites, like Salary, Glassdoor, and PayScale, which crowdsource compensation information by company, position, industry, and location.
Cruz Law Can Help Determining reasonable compensation can be a tricky proposition. Contact us for support, and we’ll help you to determine and document your compensation, so if you are audited, we can prove that you engaged in an analysis to choose the right number for your salary. Whether you need assistance determining how much to pay yourself, help filing your S Corporation election, or you need support keeping up with your LLC's administrative formalities, we’re here for you. As your Family Business Lawyer™, Cruz Law offers you trusted guidance and support to ensure your LLC is properly set up and maintained, with all of the necessary legal agreements and other resources in place. We can also provide you with a variety of business systems, which will not only make your operation more efficient, but can also establish a clear separation between your business and personal finances, which is a vital part of maintaining your entity’s liability protection. Finally, as your Family Business Lawyer™, we will also make sure that you are in full compliance with the various state laws and administrative formalities required to maintain your entity and safeguard your personal assets. Contact us today at (907) 313-9796 or firstname.lastname@example.org to get started.
This article is a service of Blyss Cruz, Family Business Lawyer™. We do not just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself, your business, and the people you love. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the Legal, Financial, Insurance, and Tax systems you need for your business. You can begin by calling our office today to schedule a LIFT Business Session and mention this article to find out how to get this $750 session at no charge.