In the last post, we discussed that one primary difference between California LLCs and S-corporations is how California taxes them. Another significant difference that you should consider is how your income as the owner will be classified for tax purposes.
The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. It is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.
On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways. The first, like LLC members (owners), is through ownership distributions. These are withdrawals of the business’ profits. The second method, which is not available to LLC members, is through a salary. In fact, an owner-employee of an S-corporation is required to take a “reasonable salary” before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business. The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions. This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business. You could, for example, take out $20,000. However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.
An S-corporation’s net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.
Regardless of whether your business is structured as an LLC or as an S-corporation, the business’s profits are passed through to the owners and subject to income taxes. They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.