Tax Consequences of Creating an S-Corp Versus an LLC

November 27, 2012

Many Sacramento small business owners, when establishing their business for the first time, are confronted with an important decision: Should their business be organized as an S-Corporation or as a Limited Liability Company? The choice can have a tremendous impact on the manner and extent to which the business and its owner are taxed. For this reason, most novice business owners rightfully contact a Sacramento small business attorney for better understanding of how the type of business entity can affect taxation.

In many respects, there is little difference between the characteristics of an S-Corporation and a Limited Liability Company. Both entity types are created at the state level by filing various incorporation papers and maintaining certain regulatory filings. Both entity types legally differentiate their owner from the business itself. Both business entity types offer limited liability protection so that the owner can segregate his or her personal assets from the business’s assets. This often makes the prospect of litigation far less onerous and terrifying.

The main difference between an S-Corp and a Limited Liability Company, however, is the way the Internal Revenue Service chooses to collect taxes from their owners and employees. In an LLC, the IRS does not tax the earnings of the entity itself, but rather the earnings that the member accumulates through the LLC. A sole LLC owner, therefore, would pay a self-employment tax rate on his or her own personal tax returns.

By contrast, an S-Corp is taxed in its own right by the IRS. The S-Corp itself files a business tax return. Then, instead of dispersing a member’s share of income like in an LLC, the S-Corp has to pay its owner (and employees) a “reasonable salary.” From this reasonable salary, the IRS computes the owner’s (or employee’s) personal income tax liability.

The problem with this setup is the vagueness of “reasonable salary.” It roughly means a salary that is commensurate with a person of one’s same ability in the same industry and geographic area. Computing this figure is easier said than done, and can have huge tax consequences. If the salary paid out to the person from the S-Corp is too low, an IRS auditor might conclude that the person is trying to evade taxes by keeping most of the assets within the business. This person may be trying to appear more impoverished than he or she really is in order to pay a lower tax rate, and it may be interpreted as tax fraud. On the flip side, if the salary paid out to the person from the S-Corp is too high, that person may be shouldering a heavier tax burden than similarly skilled people in the same industry and geographic area.

If you are having trouble deciding whether to incorporate as an LLC or an S-Corp, a Sacramento business lawyer can give a more extensive explanation of the pros and cons. Similarly, if you are having trouble determining a “reasonable salary” under the S-Corp designation, the same attorney can help nail down a figure that is acceptable to you and to the IRS.

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