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February 22, 2006

A few weeks ago UM-KC Tax Professor Christopher R. Hoyt pondered why S corporations remain popular, given the existence of LLCs. We weight in with our thoughts. Prof. Hoyt is back today at the TaxProf Blog with musings that echo some of our thinking.

Prof. Hoyt:

An important choice-of-business entity consideration concerns employment taxes. A sole proprietor of a service business will pay both the employer and employee share of OASDI and health insurance taxes (with minor adjustments) on all earned income. The same result occurs if the person forms a single-member LLC. If, however, that individual forms an S corporation and takes a small salary, some of the profits will be taxed to the shareholder without being subject to employment taxes.

Tax Update:

Self-employment and FICA taxes: While the IRS is trying its best to frighten people in this regards, S corporation shareholders still often have more ability to reduce employment taxes than LLC members. S corporation K-1 earnings aren't self employment income, while LLC earnings usually are, at least for active members. The continuing uncertainty over how LLCs are to be treated for self-employment taxes doesn't help.

Prof. Hoyt has this pretty chart, from a Senate Report, showing how S corporation shareholders take advantage of the "John Edwards shelter":


Prof. Hoyt concludes:

With testimony like this in the Senate, it seems to me that it will only be a matter of time before we have legislation to put S corporations on par with LLCs when it comes to employment taxes. If that happens, then from a federal tax perspective it seems to me we should see more LLCs. Interesting, though, how some states have franchise taxes that discourage LLCs.

My view: legislation expanding self-employment tax is unlikely outside of broader Social Security solvency legislation or major tax reform. When the Treasury last tried to bring order to the murky self-employment tax status of LLCs, the political backlash was so severe that they haven't touched the issue in the nine years since. That backlash was nothing compared to the lobbying effort that would erupt if they try to subject S corporation K-1 income to self-employment tax.

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