LLC vs Corporation Payroll Rules: How Should You Pay Yourself?
When it comes to handling payroll, the entity type of the business plays a significant role. Whether the entity is an LLC, a corporation, or a sole proprietorship, understanding the differences in payroll rules is crucial. This article will break down the key distinctions so you know how to pay yourself correctly.
Note: Our recommended payroll software is Gusto. If you are not familiar with Gusto, we encourage you to read the Gusto software review on our blog.
What is Self-Employment Tax?
Small business owners MUST understand what self-employment tax is and how your personal income and income taxes can be impacted based on the business entity you have. It consists of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the payroll tax withheld from an employee’s wages by their employer. Self-employment tax must be paid by sole proprietors, partners in a partnership, and owners of LLCs who are not considered employees of their business.
The self-employment tax rate is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. Unlike traditional employees, self-employed individuals must pay both the employer and employee portions of these taxes. This tax is calculated on net earnings from self-employment, which are reported on the individual's tax return using Schedule SE. Paying self-employment tax is crucial as it contributes to the individual's coverage under the Social Security system, ensuring they receive benefits in retirement.
How S Corporations and C Corporations Impact Self-Employment Tax
Both S Corporations and C Corporations can help business owners reduce their self-employment tax liability through structured payroll practices.
How S Corporations Reduce Self-Employment Tax
S Corporation owners who work for the business must receive a reasonable salary. This salary is subject to payroll taxes (Social Security and Medicare), but additional profits can be distributed as dividends, which are not subject to self-employment tax. This structure can reduce the overall self-employment tax liability because only the salary portion is subject to payroll taxes.
Summary: S Corporation owners pay payroll taxes on their salary but not on dividends, reducing self-employment tax liability. While this may sound like the best ‘tax saving’ opportunity, that’s not always the case. You absolutely must speak to a qualified tax professional and have them complete an analysis to determine whether or not an S Corporation makes sense and if it will actually benefit you tax-wise. Our firm specializes in these types of analysis services and in working with S Corporations. Please apply to work with us if you’d like to learn more!
How C Corporations Reduce Self-Employment Tax
C Corporation owners who work for the business also receive a salary, which is subject to payroll taxes. The corporation pays the employer portion of these taxes, effectively splitting the tax burden between the corporation and the individual. Dividends paid to shareholders are not subject to self-employment tax, though they are subject to income tax, which helps reduce the overall self-employment tax liability.
Summary: C Corporation owners pay payroll taxes on their salary, with the corporation covering part of the tax burden, while dividends are not subject to self-employment tax.
Understanding Payroll for an LLC vs Corporation
The way you handle payroll varies significantly between an LLC and a corporation. Knowing these differences can help you make informed decisions about how to pay yourself and manage your business finances.
H2: How Payroll Works for a Limited Liability Company (LLC)
For LLCs, payroll rules depend on whether the LLC is a single-member or multi-member entity or if the LLC is elected to file as an S Corporation. Here's a breakdown of how payroll operates within an LLC structure.
How Should Single-Member LLCs Handle Payroll?
Single-member LLCs are treated as disregarded entities for tax purposes. This means the business income is reported on the owner's personal tax return using Schedule C. Owners are not considered employees and do not receive a salary. Instead, they take draws from the business and the businesses profits are subject to self-employment tax.
Summary: Single-member LLCs report income on the owner's tax return, take draws instead of a salary. The owner of the single-member LLC is not allowed to be an employee nor paid a W-2 salary.
Payroll Considerations for Multi-Member LLCs
Multi-member LLCs are treated as partnerships. Each member reports their share of the business income on their personal tax returns. Members are not employees and do not receive salaries. Profits are distributed among the members.
Summary: Multi-member LLCs distribute profits to members, who report income on their personal tax returns. The members of the multi-member LLC are not allowed to be employees nor paid a W-2 salary.
Can LLCs Elect to be Taxed as a Corporation?
An LLC can elect to be taxed as a corporation by filing IRS Form 8832. An S-Corporation election then requires its shareholders, who are then treated as employees, to be paid a salary. The entity must withhold and pay all payroll taxes.
Summary: LLCs can elect corporate taxation, enabling them to pay salaries and handle payroll taxes. Shareholders of the LLC are required to be paid a reasonable salary as a W-2 employee.
Managing Payroll in a Corporation
Corporations have more structured payroll requirements compared to LLCs. The following sections explain the payroll rules for both C Corporations and S Corporations.
Payroll Rules for a C Corp
C Corporations are separate legal entities and must adhere to specific payroll regulations. They must withhold federal and state taxes from employee wages and pay employer payroll taxes.
Summary: C Corporations are responsible for withholding taxes and paying employer payroll taxes.
Payroll Rules for an S Corp
S Corporations, like C Corporations, must withhold federal and state taxes from employee wages. However, S Corporation shareholders who work for the company must receive a reasonable salary, which is subject to payroll taxes. Additional profits can be distributed as dividends, which are not subject to payroll taxes.
Summary: S Corporations must pay shareholders a reasonable salary and withhold payroll taxes. Shareholders can also receive distributions which are not subject to payroll taxes.
Should You Elect to Have S Corporation Status for Your LLC?
Electing S Corporation status can benefit LLCs by allowing owners to receive salaries and distributions. This can reduce the amount of self-employment tax owed.
Summary: Electing S Corporation status can reduce self-employment taxes by allowing salary and distribution payments. While this may sound like the best ‘tax saving’ opportunity, that’s not always the case. You absolutely must speak to a qualified tax professional and have them complete an analysis to determine whether or not an S Corporation makes sense and if it will actually benefit you tax-wise. Our firm specializes in these types of analysis services and in working with S Corporations. Please apply to work with us if you’d like to learn more!
Understanding the Difference Between S and C Corporations
Both S and C Corporations offer liability protection and are separate legal entities, but they differ in taxation and operational requirements.
Taxation Differences
C Corporations are subject to double taxation. The corporation pays taxes on its profits, and shareholders pay taxes on dividends. S Corporations, on the other hand, have pass-through taxation, meaning profits and losses are reported on shareholders' personal tax returns, avoiding double taxation.
Summary: C Corporations face double taxation, while S Corporations benefit from pass-through taxation.
Operational Requirements
C Corporations typically have more formalities, including a board of directors, annual meetings, and comprehensive record-keeping. S Corporations have fewer formalities but are limited to 100 shareholders and must adhere to specific eligibility criteria.
Summary: C Corporations have more operational formalities, while S Corporations have shareholder limits and eligibility requirements.
Sole Proprietors and Payroll: Key Considerations
Sole proprietors face different payroll rules compared to LLCs and corporations. Here are some essential points to consider.
How Do Sole Proprietors Pay Themselves?
Sole proprietors are not considered employees and do not receive salaries. They take draws from the business, and the income, expenses and profits are reported on their personal tax returns using Schedule C. Sole proprietors are responsible for paying self-employment taxes.
Summary: Sole proprietors take draws and report income on their personal tax returns.
What Are the Tax Implications for Sole Proprietors?
Sole proprietors must pay self-employment taxes on their net earnings. This includes both the employer and employee portions of Social Security and Medicare taxes.
Summary: Sole proprietors pay self-employment taxes on net earnings.
Should Sole Proprietors Consider Forming an LLC or Corporation?
Forming an LLC or corporation can provide liability protection and potential tax benefits. LLCs offer flexibility in management and taxation, while corporations provide a more structured approach and possible tax advantages.
Summary: Forming an LLC or corporation can offer liability protection and tax benefits.
Tips for Transitioning from Sole Proprietorship to an LLC or Corporation
Transitioning to an LLC or corporation involves several steps, including filing the necessary paperwork and establishing an operating agreement. Consulting with a business attorney and a tax professional can help ensure a smooth transition.
Summary: Transitioning to an LLC or corporation requires filing paperwork and creating an operating agreement. It’s best to speak to a business attorney and a tax professional.
FAQs About Payroll for LLCs, Corporations, and Sole Proprietors
What is the main difference between LLCs and corporations regarding payroll?
LLCs generally do not pay salaries to members, whereas corporations pay salaries to the shareholders which aresubject to payroll taxes.
Can a single-member LLC pay themselves a salary?
No, single-member LLC owners take draws from the business instead of receiving a salary.
How does an LLC elect to be taxed as a corporation?
An LLC can file IRS Form 8832 to elect to be taxed as a corporation, allowing it to pay salaries and withhold payroll taxes. If you’re completing a late election filing, then you must complete a late election filing via IRS Form 2553.
Are S Corporation shareholders required to receive a salary?
Yes, S Corporation shareholders who work for the company must receive a reasonable salary, which is subject to payroll taxes.
What are the benefits of forming an LLC for a sole proprietor?
Forming an LLC can provide liability protection, flexibility in management, and potential tax advantages compared to a sole proprietorship.
For personalized guidance on whether or not a S Corporation makes sense for you we invite you to apply to work with us. Our experts can help you navigate the complexities of payroll, tax planning for therapists and dentists, bookkeeping for therapists and dentists, and tax preparation for therapists and dentists, ensuring you make the best choices for your business entity.