A limited liability company handles employment taxes differently than an S corporation only when the LLC accepts the default classification from the Internal Revenue Service to be treated as a sole proprietorship or partnership. An LLC, however, can elect to be classified as a C or S corporation, in which case payroll taxation is the same, though such an election does have an impact on income taxes, and for a C corporation imposes a corporate tax.
Payroll And Self-Employment Taxes
An LLC under the default status cannot pay its members, as owners are called. Instead, all profits are divided among the members. “Member managers,” those owners who are actively involved in running the business, must pay self-employment tax on their portion of the profit up to $106,800 at a rate of 15.3 percent. For income above $106,800, only the Medicare portion of SE tax is levied, 2.9 percent. An owner or shareholder of an S corporation who actively participates in the business must be paid a “reasonable compensation” based on the standards of the industry in which the company operates, and the corporation pays the payroll tax, the equivalent of self-employment tax.
Advantages of LLC
In companies where any share of profits would not exceed the reasonable wage standard paid to an owner-employee of the company, an LLC’s member manager would pay the same percentage in self-employment tax as an S corporation pays in payroll taxes for the wage of an active shareholder. But an LLC does not have to deal with the paperwork and record keeping associated with payroll, or incur additional expense if the LLC needs to hire accounting help to handle payroll.
Profit Share Differences
The entire profit and loss of an LLC and an S Corporation is reported on members' or shareholders' personal tax returns, even if not all of the profit is distributed. Shareholders of an S corporation must distribute shares equal to the percentage of ownership of each shareholder. An LLC, however, can attribute shares of profit disproportionate to the capital investment of each of its members. Member managers can receive a higher percentage of profit share in return for their services, but their entire share of profit is subject to self-employment tax.
Read More: Tax Differences Between an LLC & a Sole Proprietorship
Advantages of S Corporation
If an LLC member manager’s share of profit exceeds the reasonable wage standard, his self-employment tax would be more than the payroll tax for an active shareholder in an S corporation with the same income. In an S corporation, any income share above a wage paid to a shareholder is considered passive income, and is not subject to employment tax, resulting in a significant savings if profits are high enough.
When an LLC’s profits are high enough to make the tax treatment of an S corporation attractive, its members can elect to change the LLC’s tax classification from partnership to S corporation. But that may be a bad choice unless the profit is sustainable. Once an LLC elects to change its tax classification, IRS regulations prevent the company from changing the tax classification again for another five years. Active shareholders of an S corporation may wish to reduce the amount of their wages to receive more in profit shares not subject to employment tax. The IRS, however, pays close attention to wages shareholders earn in S corporations. It if deems the wage is too low, the IRS can subject a shareholders entire income, wage and profit share to employment taxes.
Tom Chmielewski is a longtime journalist with experience in newspapers, magazines, books, e-books and the Internet. With his company TEC Publishing, he has published magazines and an award-winning multimedia e-book, "Celebration at the Sarayi." Chmielewski's design skills include expertise in Adobe Creative Suite's InDesign and Photoshop. He holds a Bachelor of Arts in English from Western Michigan University.