LLC or S corporation? Owners of small businesses face this question every time they start a new business or decide to shift from the sole proprietor or partnership model of doing business. If the business incorporates, it usually elects S corporation status with the IRS to allow it to avoid corporate income taxes. If the business organizes as a limited liability company, it is commonly treated as a partnership for income tax purposes which also allows the business to avoid double taxation.

For most small businesses (those with just a few owners, most of whom are actively involved in the business) the LLC is attractive because it not only allows for pass-through tax advantages, but its management and ownership options are more flexible and easier to manage than the traditional corporate model. (There are other tax issues, of course.)

LLCs have one significant disadvantage when all or most of the owners are involved in running the business and it chooses partnership tax treatment: all of the profit allocations in an LLC taxed as a partnership will be subject to self-employment tax. Corporations taxed as S corporations can limit the adverse effect of self-employment taxes by allocating its profit distributions between wages and dividends.

The solution, once again demonstrating the flexibility of LLCs, is for the LLC to elect to be treated as an S corporation for income tax purposes.

Employee-owners of LLCs taxed as partnerships pay a 15.3% self-employment tax on their income up to $90,000 and a 2.9% self-employment tax on income in excess of $90,000. S corporation employee-shareholders are not subject to self-employment taxes on their dividends if the S corporation has made reasonable salary payments throughout the year. Many corporations implement a wage reduction strategy by separating employee-owners’ compensation into wages and distributions. In contrast, employee-owners of partnerships electing LLCs may not separate the LLC’s income into distributions and wages in order to reduce their self-employment/Medicare tax.

Obviously, the lower the business sets its salaries (and the higher the distributions), the greater the potential savings. Businesses, however, should be wary of going too far with this strategy. The IRS has recently commented on entities using corporate distributions in lieu of salary payments in an effort to avoid or reduce their employment taxes. As this strategy appears to be on the IRS’s "audit watch list," businesses should remember that corporate officers are employees of the corporation if they perform substantial services for the corporation and the compensation they receive for those services, which is subject to employment taxes, must not be unreasonable in amount.