With the increase in popularity of shows such as Shark Tank and The Profit, there has been a significant increase in entrepreneurs starting new businesses. There are numerous reasons why owners should form business entities. One of the most common questions that we receive is about the type of business entity that a business owner should form. Many business owners wish to form a limited liability company (“LLC”). However, subchapter S corporation (“S Corp”) provides several tax advantages that are unavailable to LLCs.
First, formation of an S Corp allows shareholders to reduce their self-employment tax liability. Self-employment taxes are based upon an individual’s self-employment income for the year. Self-employment tax consists of old-age, survivors, and disability insurance (“OASDI”) and hospital insurance. OASDI is taxed at a rate of 12.4% of an individual’s self-employment income. There is a cap on the amount of self-employment income that is subject to the OASDI component of the tax. This cap, commonly referred to as the social security taxable wage base, is $127,200 in 2017 and is indexed for inflation (resulting in a maximum tax of $15,772.80). Conversely, the health insurance component of self-employment tax is computed at a rate of 2.9% of all of an individual’s self-employment income. However, the .90% tax on compensation in excess of $250,000 is not applicable to the distributive share of income in an S corp.
S Corp shareholders do not pay self-employment taxes on income that is allocated to them. If an S Corp shareholder performs services for a corporation as an employee, the corporation must pay the shareholder reasonable compensation. The compensation of an S Corp shareholder is subject to a tax under the Federal Insurance Contributions Act (“FICA”), which is computed similarly to the self-employment tax as well as the Federal Unemployment Tax Act (“FUTA”). There is no self-employment tax liability or FICA or FUTA tax liability to the extent that an S Corp shareholder’s pro rata share of a corporation’s income exceeds reasonable compensation paid in consideration of the shareholder’s services. A member of an LLC must include all net earnings from that member’s distributive share of the LLC’s business income for self-employment tax purposes.
An S Corp may offer deferred compensation benefits to employees that are not available to employees of an LLC. An employee stock ownership plan (“ESOP”) may own stock in an S Corp. An S Corp ESOP may also offer additional opportunities for income tax deferral because the income of an S Corp that is allocated to an ESOP is not taxed as unrelated business taxable income. Accordingly, no tax is imposed on an ESOP’s pro rata share of income from an S Corp until that income is distributed to the employees.
Finally, an S Corp may participate in tax-free reorganizations with other corporations while LLCs generally may not, which affords S Corps an advantage in mergers and consolidations. Under certain circumstances, however, an LLC may be preferable to an S Corp if the entity to be combined with the LLC is a partnership, a limited partnership, a limited liability partnership or another LLC. A merger or consolidation between an LLC and a corporation is generally a taxable event but an LLC and another entity that is classified as a partnership may generally merge or consolidate on a tax free basis.
Michael Salad is an attorney in Cooper Levenson’s Business & Tax and Cyber Risk Management practice groups. He concentrates his practice on estate planning, business transactions, mergers and acquisitions, tax matters and cyber risk management. Michael holds an LL.M. in Estate Planning and Elder Law. Michael is licensed to practice law in New Jersey, Florida and the District of Columbia. Michael may be reached at 609.572.7616, 954.889.1850 or via e-mail at firstname.lastname@example.org.
Peter Fu is an attorney in Cooper Levenson’s Business & Tax and Cyber Risk Management practice groups. He concentrates his practice on sales and use tax, enterprise risk management, and commercial transactions. Peter is licensed to practice law in New Jersey and Florida. Peter may be reached at 609.572.7556 or via e-mail at email@example.com.