Understanding Salary Distribution in an LLC Taxed as an S Corporation

When considering the complexities of organizing a business, it's essential to understand the implications of different tax structures, such as an LLC taxed as an S Corporation. This article aims to clarify how salary is distributed in this specific scenario, helping business owners navigate the intricacies of such tax structures.

Complex Organization: Are the Benefits Worth the Cost?

The decision to structure a business as an LLC taxed as an S Corporation can add layers of complexity and impose additional costs. The primary cost driver here is the requirement for specialized accounting, tax, auditing, and legal services. While such a structure can have unique benefits, it is crucial that owners understand the costs and workflows involved. If the rationale behind this setup is unclear, business owners should seek a second opinion or consult a more suitable advisor before proceeding.

‘If you have been advised to do that for some reason but don’t understand how the salary would work, I suggest you find a better advisor or get a second opinion before complicating your new business right from the start for no good reason.’

Members and Shareholders: Clarifying the Structure

Based on the term used in the provided context, it seems there may be multiple LLCs involved. For simplicity, let’s clarify the structure:

There is one LLC that has elected to be taxed as an S Corporation. There may be another LLC that is a member of the above-mentioned S Corporation, but this second LLC is not necessary for an LLC taxed as an S Corporation.

For the LLC to be the sole shareholder of the S Corporation, it must be a disregarded entity, meaning for tax purposes, the LLC does not exist as a separate entity. This structure means that the LLC is treated as an extension of the owner.

Salaries in an S Corporation: Detailed Distribution

In an LLC taxed as an S Corporation, the method of distributing wages serves the primary purpose of reducing the owner's tax burden by shifting income to lower tax brackets. In an S Corporation, the LLC can employ the owner and pay a salary, following which the remaining profit can be distributed as dividends. This dual distribution mechanism ensures that the owner is paid a salary subject to withholding, while the remaining profit can be paid as dividends, potentially avoiding self-employment taxes on the full income.

Here’s how it works:

Direct Salary Payment: You, as a member of the S Corporation, receive a salary. This salary is subject to FICA (Federal Insurance Contribution Act) Medicare and state and federal withholding. State and Federal Unemployment Taxes: You are also subject to state and federal unemployment taxes only on the portion of earnings paid as wages. Dividends/Distributions: Any remaining profit is distributed as dividends to you, which are not subject to withholding but are taxed at the individual’s income tax rate, reported on Form K-1 at the end of the year.

It’s important to note that this setup is justified by a few private letter rulings from 2008, indicating that a disregarded entity can be used as the shareholder of an S Corporation. However, there is an added risk of inadvertent revocation of S status, which necessitates careful management and compliance.

Seek Professional Guidance

Considering the complexity and importance of tax compliance, it is critical for business owners to engage with a competent CPA or tax professional. Missteps in this area can lead to costly legal and financial ramifications. Here are some key points:

Always consult a CPA or tax professional who can guide you through setting up and managing an S Corporation. Do not attempt to file taxes for an S Corporation without professional assistance; errors can be costly and time-consuming. Avoid hiring a subpar advisor; seek multiple opinions to ensure you are making well-informed decisions.

‘The only possible reason I can even think of is to charge you for two entities managing two sets of tax returns for business: SCorp LLC and then ultimately having to do most accounting from your personal financials and books. ’

In conclusion, while an LLC taxed as an S Corporation can offer certain benefits, it is crucial to fully understand the implications and seek professional guidance. By doing so, business owners can navigate the complexities of such tax structures effectively, thereby minimizing potential risks and costs.