An LLC is a pass-through entity unless you tell the IRS otherwise. In other words, profits and loses are passed through to the LLC’s owners. One reason an LLC would want to be taxed as an S corporation is to save money on self-employment taxes (i.e. medicare & social security). As of the writing of this article, self-employment taxes equaled 15.3% of the income that passes through to the LLC’s owners.
If an LLC elects to be taxed as an S corporation, the owners who are also employees only pay self-employment taxes on their salary and not on the total amount of the pass-through income.
For example, if John Doe owns 100% of ABC, LLC which has $100,000 in profits in 2013. John will have to pay 15.3% on the $100,000 profit or $15,300 plus John’s income tax bracket rate if the LLC followed the traditional tax classification approach. If John was also an employee and he paid himself a reasonable salary of $50,000, John would only have to pay 15.3% of his salary for a total self-emplyment tax burden of $7,650.
Downside to S Corporation Status for an LLC
It is important to note that there are many headaches to having w-2 employees. Each time you run payroll, you have to withhold taxes and pay the IRS and the Texas Workforce Commission. The LLC would have to file quarterly and annual reports and annual tax corporate tax returns. The LLC must also follow all Texas and federal employment laws as it will have to have w-2 employees to take advantage of the self-employment tax savings.
See more on LLC Taxation → See what is required to be taxed as an S corporation → See more on this topic on the IRS website → How much does it cost to form a Texas LLC? How long it takes to create a Texas LLC?
*Please note that tax issues are complex and we are business formation attorneys, not tax specialists. As such, we must recommend that you consult a tax professional if you have specific questions or special circumstances. According to IRS Circular 230 to ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this writing was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.