LLC vs. S-Corporation, Round 1

When setting up a business and deciding on entity type, most people are looking for 1) liability protection and 2) tax savings – specifically lowering self-employment tax liability.  For small businesses, the two best options are the LLC or the S-Corporation, and many tax or legal professionals seem to advocate for one team or the other so it is hard to know what entity is truly best for your business.  Well, I am not your advisor and I have been on both teams, so hopefully I can provide you with some balanced information and after a couple rounds, hopefully we will have a winner for your business…

Will the business own appreciating property like real estate?

If your business has anything to do with real estate rentals or owning and managing commercial or residential property, then LLC is the early winner.  This is vitally important – you should never put real estate into a corporation.  If a CPA or tax practitioner recommends this for a new small business, I would consider it malpractice.

Basically, if you put real property into an S-Corporation, then you are going to have a taxable event if you transfer it out of the corporation in the future and you will pay tax based on the fair market value of the property at that time.  I could tell you some horror stories on this issue, but trust me – if you have a residential or commercial property, put it in an LLC.
LLCs are perfect for real estate as you can move the property in and out of the entity without any taxable events.  Plus, they are much easier to setup, administer, and report for tax purposes.  Even better, if you have one owner, you can use the single-member LLC for your real estate and then the tax reporting is simplified so that you only have to complete a Schedule E as part of your personal return.

How many owners will the business have?

This is another important question to look at upfront, as it can result in a knock out in round one.  If you will be the sole owner of the business, then your options are limited to the following:

Single-member LLC (SMLLC)

The only LLC offering for the single-owner business is a great option for easy setup, administration, and tax reporting; however, it is going to cost you in the form of self-employment tax.  To the IRS, The SMLLC is no different than a sole proprietorship – in fact, the SMLLC is reported on Schedule C just like a sole proprietorship.  Unfortunately, this means that you will pay self-employment tax (15.4%) on the entire amount of your net taxable earnings.  This can really add up – especially if you are a consultant with few expenses and/or minimal capital asset needs.  After a few years of paying a hefty tax bill, most business owners are willing to put up with some extra administration and tax prep costs in exchange for a much lower tax bill via use of the S-Corporation while paying themselves a reasonable wage.

S-Corporation

The big winner for single-owner businesses is clearly the S-Corporation as most business owners can end up saving thousands.  With an S-Corporation, you do not pay self-employment tax on the earnings, BUT the owner must pay himself a “reasonable” salary, which means you are paying payroll taxes on the Federal and state level.  Usually, if you sit down with a CPA and lay this all out, they should be able to give you a ballpark of your tax savings each year; however, there are costs related with this:

  • Legal costs – it is not cheap to setup, but I would never suggest a D.I.Y for an S-Corporation.  Get it setup right and avoid legal problems later.
  • Accounting Fees – keeping your accounting data on a spreadsheet may not cut it anymore – especially if you use a lot of credit cards and loans.  Be prepared to pay a bookkeeper or an accountant to get your books setup right so that the tax preparation goes smoothly.
  • Tax Prep fees – S-Corporation returns require much more work and typically range from $750 – $2000 or higher depending on complication.  Plus, you now have to file quarterly payroll tax returns and payroll to process, which can run you about $95/quarter even with one employee using ADP, Paychex, of your CPA.

If your savings are still substantial after factoring in these costs, then you should definitely go with the S-Corporation, but make sure you have a good lawyer and a good CPA that you like as you will be talking to them frequently for the first few years.

Well, round 1 is in the bag and we are tied at 1 a piece.  In round 2 we will deal with issues for businesses with more than owner.

Just remember – never choose an entity for your business without consulting a CPA and lawyer as every situation and business is unique.  Give me a call at 503.224.8844 if you need a CPA or a lawyer to help you with your new business.

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About Brian Germer, CPA

CPA with Parsons and Germer CPAs, LLP in Portland, OR

9 thoughts on “LLC vs. S-Corporation, Round 1

  1. What about the fact that in the first year many businesses have a Net Operating Loss (NOL)? If you are a single member LLC and have a NOL, then you do not have to pay any self employment tax. However, if you are an S corporation, I question whether or not the IRS will still make you take a reasonable salary.

  2. Good point! Yes, reasonable salary can still be an issue the first year, but I think if you are not showing any distributions and the loss is not driven by self-rental payment, then you have a much stronger position. Basically, you just prove that the business could not afford to pay a salary the first year. If you wanted to further protect yourself, you could put some deferred compensation in the minutes.

    However, if there were distributions, then you should pay some payroll or reclassify them against loan from shareholder as repayments.

    Another strike against the S-Corp with regard to first year NOLs is basis. If the shareholder received loans from other people or did not contribute enough in capital or in loans, then the loss could be suspended.

  3. for an S-corp, business profits/losses pass thru to the owner and then get taxed on the personal income tax return.

    however, if it is a business loss, it offsets any personal income, hence reducing the overall tax paid.

    so – what if I take more in salary, hence creating a business loss. Then applying that business loss to my income on the personal tax return, would result in overall less taxes paid? no? yes? faulty thinking??

  4. Thank you for the question!

    The problem is that the salary is subject to FICA and Medicare (employer and employee) tax, whereas the flow-thru profits that would be taxed on the personal return are ordinary income only subject to individual income tax.

    The point of the S-Corporation is that you are trying to play the FICA game and minimize FICA tax by paying a low but reasonable wage. If you increased your wage to make a loss, the loss and the W-2 income effectively cancel each other out and you are just paying a larger amount of FICA tax probably equivalent to the amount of SE tax a Schedule C filer would pay…so in a sense you are losing the main benefit of being an S-Corporation. Plus, even though your individual tax may be low, it would still not give you as much savings as lowering your FICA and Medicare tax – especially with how low rates are right now.

    Sorry, I wish something like that would work, but they get you one way or another with this issue. Good question though – you always want to try and think outside of the box with this stuff.

    • In a somewhat related topic: I have a Sole Prop – Law Firm that specializes in Personal Injury Law that wants some limited liability protection themselves and was wondering what is the more common or required legal entity selection (Professional Corporation, LLP or LLC) for a Law Firm. Also, they want to know whether Law Firms can elect to be taxed as S-Corp to avoid PSC flat tax of 35%, if PSC taxation is triggered for this legal entity selection ?

      • Sorry – it was a long, busy holiday and I am finally catching up on the blog…

        Most law firms – at least in this state – are organized as LLPs more often than PCs, which is most likely due to the fact that you are given protection against vicarious liability for negligent acts committed by a co-partner with an LLP. However, for a sole owner law firm, a PC S-Corp is probably the better choice – either that or the SMLLC if they do not want the extra paperwork or to pay themselves payroll.

        S-Corp status will help them avoid PSC tax. PSC is only for C-Corps, and very few new entities are starting as C corporations these days.

  5. Thank you Brian. I thought I had heard somewhere, but can’t seem to find it in writing, that an LLP entity cannot elect S-Corp status, and therefore would file a 1065 subject to SE Tax on flow thru income ? Do you agree ? I understand fully that a PC can elect S-Corp status, pay themselves a reasonable wage, then take S-Corp Distributions as long as income is generated beyond their own efforts. (ie. other employees)

  6. Can I pay myself a wage from a Real Estate Investment LLC?

    Say my 2-person RE Investment LLC (my wife and I) was my (our) only income source. Could I pay tax-deferred items such as medical Insurance premiums and HSA contributions? Could I pay both myself and my wife Reasonable “Earned Income” to qualify for tax-deferred Qualified Retirement Plans and Profit Sharing?

    I appreciate your thoughts.

  7. Hi,

    I am in process of setting up S-Corp in Nevada. I am the single owner. I would also like my daughter (10yr) to be added as owner. Is there any issue with it? Do I need to pay “reasonable wages” also?

    Thanks,

    Kevin

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