LLC vs. S Corp: Which Offers Better Tax Savings?
February 7, 2024
Understanding business entities and tax structures can save you a tremendous amount of time, money and potential headaches down the road. Limited liability companies (LLCs) and S corporations (S corps) are often talked about in conjunction with possible types of business entities, but it is not a simple choice between one or the other.
Unlike a C corporation, which taxes shareholders separately from the entity, both LLCs and S corps are generally subject to only one layer of taxation at the owner level, which could provide significant tax savings over the course of a business’s life. An LLC is one of four main legal business structures, whereas an S corp is a tax classification. For these reasons, it is important to know the differences between them and understand when and how they may apply.
Taxation Considerations
Similar to S corps, LLCs (and partnerships) are considered “pass-through” entities in which a business’s income and expenses flow through to the partners and are reported on the partners’ personal income tax returns. This means that the partnership does not pay income tax. Instead, it passes the profits or losses through to the owners. For tax purposes, partnerships are seen as extensions of their owners, and owners receive tax reporting through a Schedule K-1.
Not only does income pass through to each partner, but so do any deductions and credits. This means that the profits are only taxed at the personal level, avoiding the double taxation that corporations face by paying corporate income tax. Shareholders must then pay tax on their dividend shares.
LLCs and S corps treat self-employment taxes significantly differently. Self-employment taxes are different from income taxes because they apply to the net earnings of the business and are currently taxed at a rate of 15.3%. That rate is the sum of 12.4% for Social Security (for 2024, the first $168,600 of earnings is subject to Social Security Tax) and 2.9% for Medicare (no limit on taxation). In an LLC, each member’s share of income from a trade or business activity is subject to self-employment tax.
S corp shareholders’ shares of income are not subject to self-employment taxes. The IRS does, however, require S corps to pay shareholders who contribute substantial services a “reasonable” salary. This salary is subject to payroll taxes.
Rental Real Estate Considerations
It is common to own rental real estate property inside an LLC, as it offers asset protection, limits personal liability, provides a flexible management structure, allows for an unlimited number of owners, grants the ability to attract capital investments, and extends several key tax benefits. However, S corps are less frequently used to own rental real estate because they inhibit flexibility when distributing property to the owners. Additionally, S corps greatly limit the ability to utilize losses financed by debt.
With both an LLC and an S corp, profits and losses are generally allocated to each owner based on the percentage of ownership. However, members of an LLC can elect to make “special allocations,” allowing profits and losses (or other tax benefits, such as depreciation) to be passed through to each member that is not based on a percentage of ownership. This added flexibility gives the LLC structure a strategic advantage over that of an S corp.
If you have or plan to have more than one rental property, it may be beneficial to set up a separate LLC for each property. This is because all assets of an LLC are “exposed” if a lawsuit should arise. Insulating both the owners and any other properties owned in a dispute is extremely beneficial. An attorney should be consulted for the limited liability risk of ownership.
Pass-through Entity Tax Elections
The pass-through entity (PTE) tax elections allow both partnerships and S corps to elect to be taxed at the entity level for state income tax purposes only. The key benefit of a PTE election is the federal “deductibility” of the entity’s state income taxes paid. Individual owners of PTEs can realize a federal tax deduction of state taxes via their pass-through income allocation, thereby avoiding the $10,000 Federal 1040 Schedule A limit on itemized deductions of state income tax payments, commonly known as the state and local tax (SALT) cap. Each state has different eligibility requirements and PTE election regimes that should be evaluated.
Let Us Guide You Forward
The choice of entity cannot be made as a standalone decision. All elements, including the type of activity to be conducted, availability of cash, use of leveraged debt, legal considerations, exit strategies, and retirement and estate considerations, all come into play when developing an entity strategy. It is recommended that you consult your legal and tax advisor before selecting your choice of entity.
Cherry Bekaert can help your company grow and excel, regardless of the economic climate. Our Real Estate & Construction Industry Group professionals can customize a strategic plan tailored to your business goals to cover objectives such as effective tax strategies, structuring developments and profitability analyses. We can establish strong industry relationships for you while staying ahead of trends to provide timely and actionable advice. Reach out to your Cherry Bekaert advisor to learn more about how our industry-driven insights can position you for success.
Related Guidance
Article: Making Informed Entity Selection for Real Estate Ownership
Article: Tax Advantages for Real Estate Professionals
Article: Pass-Through Entity Considerations for the Real Estate Sector
Webinar Recording: What’s New with State Pass-Through Entity Tax?