By separating salary from business profits, the owner saves a small amount in taxes by avoiding payroll taxes on the amount received as a distribution from the S-Corp.
However, the S-Corp distribution received by business owners is taxed at ordinary and regular tax rates according to their individual tax bracket.
One of the most popular ways to organize a business is as a limited liability company, also known as an LLC. LLCs require less paperwork than C corporations and S corporations, while offering owners some of the same protections against personal liability for any actions of the business.
But the real advantage of this title comes in the form of tax benefits.
LLCs offer business owners far greater tax flexibility than sole proprietorships, partnerships and other popular forms of business organization.
The key concept associated with LLC taxation is pass-through. This describes the way in which the LLC's profits can pass directly to the owner(s), without first having to pay federal corporate income taxes.
Sole proprietorships and partnerships are also taxed as pass-through entities.
These companies do not pay federal income taxes. Instead, their profits are passed directly to their owners, who pay taxes on them at their individual tax rates.
The "S Election" will cause the Corporation's taxable income to be passed through to be taxed to the Corporation's shareholders in proportion to their ownership of stock.
The single corporate tax rate then applies to the corporation's taxable income, regardless of its activity.
Since most LLCs do not require any of their members to restore negative capital account balances, the operating agreement should include a qualified income equalization provision.
After deducting reasonable compensation and other business expenses, the LLC's taxable income is reported by the member(s) as passive income, rather than as earned income subject to Social Security and Medicare contributions.
More information on the LLC taxation rules can be found in the IRS Form 3402 information document, which discusses the taxation of LLCs.
When an entity is taxed as a partnership in connection with its estate or business planning, the partners' income may be treated as self-employment income if the LLC ("limited liability company") is engaged in the business.
The main disadvantage for owners of an LLC that is taxed as a sole proprietorship or partnership is that all taxable income, which is passed through to the owners, is treated as "earned income and subject to employment taxes".
After deducting reasonable compensation and other business expenses, the taxable income of an LLC electing "C corporation" status is taxed at the corporation's tax rates on a Form 1120 Corporate Income Tax Return that must be filed each year.
The "C" corporation or taxable LLC may reimburse an executive or employee at the current mileage rate allowed by the Internal Revenue Service for business use of an automobile owned by the executive or employee.