California LLC vs Scorp
The biggest difference between LLC's and S-Corporations (S-Corp) is how they are taxed. A big myth is that LLC's save taxes. The main purpose of an LLC is asset protection, NOT tax savings. S-Corp's can potentially save thousands in taxes every year.
Taxation of LLC's
LLC's are pass-through entities, meaning that the income/loss from the entity flows on to the owner's personal income tax returns. As such, the LLC itself does not pay tax, the owners pay it. All of the net income from an operational LLC is subject to self-employment taxes (Medicare and Social Security Tax at 15.3%). This makes it an unattractive choice for businesses that are making net income in excess of $40,000 to $50,000 per year that is subject to self-employment taxes.
Taxation of S-Corp's
S-Corp's are also pass-through entities, but the net income is not subject to self-employment taxes. Instead, the officers of the company are required to pay themselves a "reasonable" salary through payroll. This amount paid which is reported on a W-2 form is the only portion subject to the 15.3% self-employment taxes. Therefore, it presents an opportunity to save significantly on self-employment taxes compared to that of an LLC or sole-proprietorship if it has net income in excess of $40,000 - $50,000 per year.
S-Corp Tax Savings Examples
Let's take a look at two examples of how powerful an S-Corp can be in the right circumstance. First, let's look at an operational business that has net income of $50,000. As a sole-proprietor or an LLC, the entire $50,000 is subject to both Federal and state income tax AND 15.3% self-employment taxes. This results in self-employment taxes of $7,650. An S-Corp with $50,000 in net income can split the income into two parts: 1) $20,000 reasonable salary reported on a W-2; and 2) $30,000 in ordinary income reported on Schedule K-1. In this case, only the $20,000 is subject to the 15.3% resulting in $3,060 in self-employment taxes. This leaves a tax savings of $3,060. The ordinary Federal and state income taxes are the same in both cases.
Next, let's look at net income from an operational business of $150,000. As a sole-proprietor or an LLC, the self-employment taxes would be $20,497 (slightly less than the full 15.3% since it is over the Social Security tax limit). An S-Corp could split the $150,000 into a $50,000 reasonable salary reported on a W-2 and $100,000 of ordinary income on Schedule K-1. The result is $7,650 in self-employment taxes. This leaves a tax savings of $19,747.
As you can see, typically the more money you make, the more an S-Corp can help you save in taxes. Remember, this is a tax savings you can get every year just by changing the organization of how you make money. Taxes are our biggest expense it life and not taking advantage of structures like this can absolutely steal your wealth. This is not to say that S-Corp's are necessarily better than LLC's. It all depends on the situation and nature of how income is being earned. Below, I have listed three primary reasons to use an LLC over an S-Corp.
Three Situations to Use an LLC
1. To hold rental property.
2. To structure an operational business with multiple partners.
3. When initially starting a business with net income less than $30,000/year and the business has asset protection concerns.
