One of the decisive points in choosing between an “S” corporation and an LLC, though, is the self-employment tax. The self-employment tax is equivalent to withholding for employees for Social Security and MediCare, but includes both the employer and employee portions; currently this is 15.3%. This is in addition to income tax.
One advantage of a an “S” corporation is that, although you must set a “reasonable” salary for any owner who is doing any work on behalf of the corporation, no self-employment tax has to be paid on any profit pass-throughs. For example, if you can reasonably set the salaries so that half of each owner’s compensation is profit pass-throughs, the owners will not have to pay the self-employment tax on those pass-throughs.
With an LLC, each owner who either
a) is empowered to sign contracts on behalf of the LLC, which includes managing members and members of LLC’s that are member-managed or
b) spend more than 500 hours in a year on the LLC’s business probably has to pay the self-employment tax on all money that he/she receives that is in addition to one’s compensation as an employee (where withholding is already being done).
While it is possible to try to avoid this by designating someone as the manager who is not a member (e.g., an affiliated corporation), that still does not help members who work more than 500 hours in a year on the LLC’s business.
There is an exception if the income arises from real estate rentals. For example, if your business is solely involved in real estate leasing, the rental income generated estate would not be subject to the self-employment tax in an LLC.
Although the choice of a business entity has to be made on a case-by-case basis, if all the owners will be individuals who are U.S. residents and less than 25% of the entity’s revenues will be from passive sources like rents, often it will be best to form an “S” corporation in order to legally avoid the self-employment tax on profit pass-throughs (versus salaries).
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