As a trusted “go-to” resource, you field many questions from business clients who depend on you for insight and information. Among those inquiries are those that can impact clients’ business entities and their personal finances.
For example, clients who are the sole owner of an LLC may wonder how electing S corporation status will affect how they get paid from their businesses. Do they take owner’s draws or get paychecks through payroll? How could opting for S corp status affect their tax situation? What else should they know?
I’ll touch on those considerations now to help you assist your clients in making informed decisions about their tax treatment options.
1. Does the single-member LLC business owner become an employee of the company after electing S Corp status? When a single-member LLC (SMLLC) elects S corp status, the owner must be put on the company payroll and receive a paycheck for the services they perform for the LLC. They do not pay themselves via owner’s draws as they would as an SMLLC, which is taxed as a sole proprietorship.
This can be advantageous for the business owner. Unlike being taxed as a single-member LLC (disregarded entity) with all profit subject to self-employment taxes, as an S corp, only the business owner’s wages and salaries are subject to Social Security and Medicare taxes.
2. Is the SMLLC/S corp owner’s payroll handled differently than for other employees? The owner’s paycheck will have income taxes, FICA tax (Social Security and Medicare taxes), and other applicable deductions withheld from it — just like any other company employee. Half of the FICA tax due is withheld from the employee’s paychecks, and the business pays the other half.
3. Can an SMLLC/S Corp owner take other income from the business? In addition to wages and salaries from working in the business, an SMLLC/S corp owner can also receive business income through profit distributions. Profit distributions are subject to income tax but not Social Security and Medicare taxes.
4. How much should a single-member LLC/S corp owner pay themselves as an employee? The SMLLC/S corp owner must take care to pay themselves a reasonable employee salary. Generally, that’s defined as an amount that other businesses pay employees in similar roles for their services.
This is important because the IRS is wary of situations where business owners pay themselves a suspiciously low wage or salary while taking generous profit distributions. That can raise a red flag that the individual is trying to game the system to pay as little as possible in Social Security and Medicare taxes.
You can find more information about what reasonable compensation considerations are on the IRS website, but here are some factors for determining reasonable compensation:
- Job duties and responsibilities;
- The individual’s training and work experience;
- Time and effort dedicated to the business;
- Payments to non-shareholder employees; and,
- Compensation paid by other businesses to their employees for comparable services.
5. Are there any situations when a business owner doesn’t become a paid employee of the SMLCC/S corporation? An SMLLC/S corp owner does not have to be put on payroll if they solely have a financial interest in the company and have hired other employees to handle the day-to-day operations and administration of the business. In that scenario, the business owner may be paid in profit distributions alone.
The bottom line
Like other decisions impacting how clients are taxed and receive income from their businesses, changing from the default LLC tax status to election as an S corporation demands careful thought. Assess each client’s unique situation and provide input as allowed by your credentials and licensing. If clients have questions outside your realm of expertise, direct them to professional resources within your network who have the required knowledge and certifications.
