LLC vs. S-Corporation: The FICA Tax Reason

Posted on August 23, 2012

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In previous articles, we have mentioned that both LLCs and S-Corporations are taxed only at the shareholder level, which puts both of them in a favorable income tax position. Thus, one might assume that the decision is tax neutral. Of course, when it comes to tax, it rarely is that simple. Many professionals, accountants in particular, will argue that one of the most compelling reasons to form an S-Corporation over an LLC is the money that an S-Corporation saves on the FICA tax.

Simply put, by classifying earnings as “distributions” rather than “wages,” shareholder-employees can pay significantly lower taxes. If your ownership is primarily owner/operator, a company may prefer the FICA benefit of an S-Corporation. The Federal Insurance Contributions Act (FICA) tax is a US employment tax imposed by the federal government on both employees and employers to fund Social Security and Medicare programs. This tax accounting means that the LLC owner/operator pays self-employment taxes (roughly 15% on the first $100,000 of profits and roughly 3% thereafter) on all of the LLC’s profits. In comparison, an S-Corporation pays self-employment taxes (again roughly 15% on the first $100,000 of profits and then 3% on profits after that) only on the amount of profit called “wages.” Suppose, for example, that a company makes $100,000 in profits. If the LLC is treated as a sole proprietorship1, the self-employment tax bill roughly costs $15,000 each year. If the company is an S-Corporation and the owner’s wage amount is set to $50,000, the self-employment tax bill roughly costs $7,500 each year. S-Corporation status in this example saves the owner roughly $7,500 annually in employment taxes.

Here is another example:

Tax Savings on an S-Corporation
Income From Sole Proprietorship (LLC): $75,000
35% Tax Rate: $26,250
15.3% Employer Matching Tax: $11,475
Total Taxes: $37,725

Salary From S-Corporation: $40,000
Dividends: $35,000
Total Income: $75,000
Tax Rate: 35%
Employer Matching Tax: 15.3%
Total Tax Bill: $32,370

Tax Savings: $5,355

Please note, however, that the IRS closely scrutinizes shareholder-employees to make sure they are receiving reasonable compensation — subject to employment taxes — before any non-wage distributions may be made to that shareholder-employee. If you elect to be an S-Corporation, you must take a reasonable wage. That word, “reasonable,” always carries some risk that the IRS will not have the same view of reasonable as you do.

Thus, the choice between an LLC and an S-Corporation in regards to the FICA tax is a little like the battle of wits between Vizzini and Westley in The Princess Bride. Vizzini wants to determine which glass is poisoned. Would Westley have given him the poison straight up, would he have given himself the poison suspecting that Vizzini would assume the poisoned glass was in front of him, or would have given Vizzini the poisoned glass knowing that Vizzini would suspect Wesley of giving himself poison to trick him? The IRS knows what I’m doing by forming an S-Corporation instead of an LLC, but do I know they know?

In The Princess Bride, in the end both glasses are poisoned, so Vizzini would have died either way, and only by spending years forming a tolerance to the poison did Westley escape unharmed. In this situation, you’re going to pay taxes either way, but which way is the most effective while also making sure you don’t end up slapped with fines and penalties by the IRS?

Mike Goodrich
Goodrich Law Firm, LLC

1 The analysis is similar for LLCs which are partnerships; a partnership LLC will just have more than one member.

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