TAX BREAK

Comparison of LLCs and Sub-S Corporations for Self-Employment Tax by Michael D. Matejka (continued)

 

 

For example, X, Y and Z form an LLC for the purpose of operating a construction company.  X will be the manager of the company and participate in the LLC’s trade or business for more than 500 hours during the year.  Y and Z will not.  X owns 100% of the class A interest, which is entitled to 10% of the profits.  X, Y and Z each own 30% of the class B interest, which is entitled to 90% of the profits. 

 

The 10% of the profits allocated to X for his class A interest is subject to self-employment tax.  However, X’s 30% share of the profits as a holder of the class B interest is not subject to self-employment tax since Y and Z do not participate in the trade or business for more than 500 hours and are not managers of the LLC and own more than 20% of the class B interest.

 

S Corporations

The shareholders of an S corporation are taxed differently. With an S corporation, salaries and bonuses paid as employee compensation are subject to Social Security and Medicare tax, but distributions to shareholders in excess of employee compensation are not, provided that the shareholder/employees are paid a reasonable compensation. 

 

Using our previous example, assume instead that X, Y and Z are each actively involved in the construction company.  If the company is an S corporation, the reasonable salaries that they pay themselves will be subject to Social Security and Medicare tax; however, the distributive share of the profits will not.  In contrast, if they were an LLC, all of their share of the trade or business income would be subject to self-employment tax since all of the members participate in the LLC’s trade or business for more than 500 hours a year.

 

Therefore, depending upon the participation of the owners, an S corporation may, in some situations, result in having less income subject to self-employment, social security, or Medicare  tax than an LLC.  This is another example of how the selection of the proper entity involves careful consideration of all of the circumstances.

 

 

 

 

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