To S-Corp or Not to S-Corp

Mar 25, 2024

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hen starting a business, owners often face the dilemma of which corporate structure to use. For smaller businesses, particularly those with only a single owner, the first three options that come to mind are operating as a sole proprietor, a limited liability company (LLC), or an LLC with S-Corp tax status. Keep in mind there are many other legal entities including partnerships and C-Corps. They all have pros and cons, but here we take a deeper dive into an LLC with S-Corp status.

Ownership, Liabilities, and Restrictions – Give and Take

An LLC with S-Corp tax status is a unique combination. This structure allows for Operating Agreement under the LLC entity, rather than By-laws of a corporation, but that Operating Agreement needs to account for the S-Corp tax status. Like a C-Corp or an LLC, an LLC with S-Corps status offers limited liability protection to their owners. But this S-Corp status makes it less flexible in its ownership structure. An LLC with S-Corp tax status is limited to 100 shareholders as a single-share class and income must be distributed in accordance with the shareholder’s proportional ownership. To that end, these shareholders are limited to U.S. citizens or residents, as well as certain tax-exempt entities. For a shareholder in an S-Corp that owns 100% of the stock, this won’t be an issue, but it could cause complications in the future should that owner elect to sell his/her shares to other investors in the future.

Tax Treatment, Income, and QBI

An LLC with S-Corp status is considered a pass-through entity. But unlike an LLC, where owners must report all income on their personal returns whose full amount is subject to self-employment tax, with S-Corp status owners can take a salary as an employee. Doing this modifies the taxes that the employer-owner must pay. The salary taken is subject to payroll taxes but not self-employment tax. The remaining profits are then distributed and are subject to ordinary income tax. This salary and dividend split allows S-Corp owners to potentially reduce their overall tax burden specific to the company. This is best witnessed via a rudimentary example for sole member (single owner):

Structure: LLC S-Corp Tax Status
Revenue: $150,000 $150,000
Expenses: $50,000 $50,000
Employee Wages: $0 $50,000
Net Income: $100,000 $50,000
SE Income Tax (15.3%) $15,300 $0
Employee Payroll Tax (7.65%) $0 $3,825
Employer Payroll Tax (7.65% + FUTA) $0 $4,245
Total Taxes Paid: $15,300 $8,070

The illustration above shows how an S-Corp status may be more tax advantageous for businesses. But to draw the conclusion that it’s a slam dunk would be taking it too lightly. Enacted in 2017, the Tax Cuts and Jobs Act (TCJA) introduced the Qualified Income Business deduction (QBI deduction) which complicates the tax calculations.

The QBI Curveball

Lasting until year-end 2025, the QBI deduction allows pass-through entities like LLCs and LLCs with S-Corp tax status to exclude up to 20% of their qualified business income from federal income taxes. However, this deduction comes with rules that make the calculations hairy. When analyzing the tax calculations here are some items to consider.

  1. The type of business. The type of business can impact whether the QBI deduction can be applied. While many business types qualify for the QBI deduction, certain defined Specific Service Trade or Businesses (SSTB) are limited.
  2. Total taxable income. QBI is also dependent on income limits and phaseouts. Not only does business income apply to this calculation, but a spouses income and any additional income from other sources may apply. For example, the 2024 total taxable income must be less than, $191,500 and $383,900 for single filers and married filing jointly, respectively, to receive the full QBI deduction benefit. However, above those income limits the QBI deduction benefit starts to phase out until it reaches zero.
  3. How an employer-owner pays themselves a salary via S-Corp status saves on self-employment taxes, yet reduces the QBI deduction because the S-Corp income is reduced by that salary.

Suffice it to say, a general rule of thumb is that with lower business income it may be best to not elect the S-Corp status while higher income may make it worthwhile. However, that general rule of thumb doesn’t always apply. The QBI deduction makes it much more difficult for a lay-person to determine if it’s worthwhile to elect S-Corp. Given that, the best course of action is to consult with a tax advisor, lawyer, and a financial advisor versed in corporate structures to help you determine which structure best suits your business and needs.

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