This article explains how “S-corp” tax status could reduce tax liability for self-employed consultants, professionals, and other freelancers.
What is an S-Corp? How is it related to LLCs and Corporations?
Limited Liability Companies (LLCs) and Corporations (C-Corps) are types of business entities that are formed at the state level.
The terms “S-corporation” and “S-corp” are short hand for a special tax treatment those entities can request from the IRS. Company founders does not form an S-corp, they elect S-corp status once they have formed an LLC or C-corp.
The default tax rules for LLCs and C-corps are not the same, and electing S-corp status provides different tax benefits for each type of entity. This article will focus on the tax benefits afforded to LLCs, a type of entity often formed by self-employed consultants, professionals, and other freelancers to operate their businesses.
How do the tax rules differ for an LLC if it elects S-corp treatment?
The default tax treatment for an LLC is to pass profit/loss to its owners (typically in proportion to their ownership). This profit and loss is declared on each owner’s tax return. For a single member LLC formed by a self-employed consultant, professional, or freelancer, that means all the profit or loss will be reflected on their personal tax return. Put another way, the LLC does not exist as a separate entity in the eyes of the IRS, and all of it’s profit or loss are reported by its owner.
By default, profits that pass through to an owner are subject to both personal income tax as well as a self-employment tax of 15.3%.
However, electing S-corp status reduces the amount of profit subject to self-employment tax by splitting the net income generated by the LLC into salary and profit distributions and eliminating the 15.3% surtax on the profit distributions.
How does this work in practice?
Once an LLC elects for S-corp status, its owner must be paid a reasonable salary. Only that salary is subject to a 15.3% tax (technically FICA payroll taxes, which is the same percentage as Self-Employment tax). The salary is also subject to income tax.
However, the remainder of the LLC’s profits are distributed to the owner and only subject to income tax.
The key takeaway is that only the salary is subject to the additional 15.3% tax, whereas before, all the profit of the LLC was subject to this tax.
In addition, half the payroll tax is paid by the LLC, which is deductible against its profits, further reducing the tax liability.
Here’s an easy to follow example
Take a single-member LLC that earns $150,000 and has $10,000 in expenses. Without an S-corp election, $140,000 is subject to both Self Employment Tax and Income Tax. The self-employment tax alone is $21,420, leaving the owner with $118,580 subject to income tax.
If the LLC made an S-corp election and paid a “reasonable salary” of $75,000, the owner would recognize nearly $10,000 in tax saving and walk away with $128,525 subject to income tax. Here’s the math:
The owner is paid a salary of $75,000. The owner pays 7.65% payroll tax – or $5737, leaving $69,268 subject to income tax.
The LLC, after paying the original $10,000 in expenses and $75,000 payroll, is left with $65,000 in profit. It also pays 7.65% payroll tax on the salary ($5737), leaving $59,262 in profit. This remaining profit is paid to the owner and is not subject to employment tax, only income tax.
So the owner walks away with this $59,262 as well as the remainder from their salary, $69,268, totaling $128,525 (versus $118,580 without the S-corp election).
In this example, the LLC that elected for S-corp status pays only $11,474 in payroll or self-employment tax. While the LLC under the default rules is subject to $21,420 of those taxes.
As noted above, the takeaway is that by taking the S-corp election and dividing the LLC’s profits into salary and distributions, self employment tax only applies to salary.
So what’s the downside?
There is additional administrative burden, so you want to make sure there are actual tax savings. This burden includes setting up a payroll system (which is relatively straightforward using online tools like Gusto) and engaging a tax preparer to properly file your returns. The business will also need regular cash flow to meet payroll and payroll taxes, but salary frequency and amount can be adjusted to account for variability. Typically if a Single Member LLC (e.g., a freelancer or consultant) has more than $100,000 of net income, S-corp election is attractive despite this additional administrative effort. There is also a large ecosystem of online tools to help manage these requirements.
What is a reasonable salary?
In order to prevent abuse, the IRS requires the salary paid to be reasonable. Generally if the salary is a majority of the LLC’s net income, it will be considered reasonable. Your tax preparer can also research comparable salaries. At the end if the day, you want to be able to justify the salary if it were scrutinized.
How do I elect S-corp status for my LLC?
You can elect S-corp status within 75 days of incorporation. You can also elect for S-corp status at the beginning of their tax year. Existing LLCs and C Corporations with a tax year that began on January 1 have until March 15, 2021, to file IRS Form 2553 (Election by a Small Business Corporation) to request S Corporation status for the tax year. Businesses that have a fiscal year other than the calendar year have until two months and 15 days after the start of their fiscal year to complete their S Corp election form.
Typically, if a business files as an S Corporation after the deadline, it will be taxed as one type of entity for part of the year and then as an S Corp for the remainder. That means it must prepare two sets of tax forms.