Q: We currently have a partnership LLC, but have heard that for tax purposes, it's better to organize as an S-Corp. We've received different opinions based on who we've talked to. Are there any hard and fast rules, or resources made available by people who aren't courting your business?
A: As this is a tax related question, let's approach it from the IRS's perspective. Suppose the firm makes a profit. In a multi-owner LLC, the IRS does not tax the LLC. The profits flow through to the individual owners. The owners report the profit as income in their individual tax returns and pay taxes based on their personal income tax rates.
Now, let us consider an S-Corp. Similar to an LLC, the IRS does not tax the profits of an S-Corp. The profits flow through to the shareholders as income on their individual tax returns and similar to the LLC scenario, the S-Corp shareholders pay tax based on their personal income tax rates. However, there can be circumstances where the S-Corp option reduces payroll taxes. For example, there are generally two ways by which a shareholder is compensated by an S-Corp. First, a shareholder can draw reasonable wages for the time and effort devoted to the S-Corp. In this case, the individual shareholder's wages are fully subjected to payroll taxes. Second, the S-Corp profit that remains after reasonable wages are paid is included in the income of the shareholder, but is not subjected to payroll taxes. This can create a tax advantage for the S-Corp option because the owners of a small business LLC may be classified as general partners and subjected to payroll taxes on both their wage and LLC profit inclusion. As is often the case with taxes, it is imperative to consult with a tax advisor regarding your specific fact pattern. It should also be noted that the IRS monitors this potential S-Corp payroll tax advantage closely as the concept of "reasonable wages" between the S-Corp and the shareholder is critical to any final tax determinations.
There are no hard and fast rules about whether a business should be an LLC or an S-Corp. The reason is that an LLC does have some legal benefits over an S-Corp. Also, the decision depends on many moving parts and can only be made by someone who fully understands your business. One way for marrying the benefits of an LLC with those of an S-Corp is to register your business as an LLC. After that, you can request the IRS to treat your business as an S-Corp. This can be done by filing a timely Form 2553 with the IRS. You would then have a business that has the legal benefits of an LLC and the potential tax benefits of an S-Corp.
Mufaddal Baxamusa is an associate professor of finance at the University of St. Thomas Opus College of Business.