Which One: LLC or S-Corp?
Starting a new business? A lot of people just follow the crowd and say, "I'll register as an LLC," and have no idea what extra taxes they're going to be paying.
Key Takeaways
Businesses are overpaying in taxes every single year because of the entity they choose.
If you plan on withdrawing all of your business profits as a distribution and have no plans of reinvesting those funds back into your business, then an S-Corp status might be for you.
You must file the appropriate IRS forms by March 15th if you want your S-Corp status to be effective in the current tax year.
If you own a business, then ensuring that you're properly structured to save the most in taxes is very important. After all, taxes are one of the biggest expense you'd have besides the tax implications and legal considerations of an LLC versus an S-Corp.
So why is entity selection or choosing between an LLC and S-Corp so important?
The process of choosing the right entity for your business is one of the most important decisions you'll make as an entrepreneur. The entity you choose plays a huge role in your personal liability in your company if you're ever faced with a lawsuit. In addition, to the legal aspect, taxation is a major reason why choosing the right entity is so important. Simply put, some entities pay more in taxes than others. Some even pay double taxation, meaning, you’re taxed on the same money twice. All in all, you want to make sure you set yourself and your business up for success in choosing the right entity is key.
If you want to know if you should be an S-Corp or an LLC, you first need to have a very clear understanding of what each is first.
What is an LLC?
LLC stands for limited liability company. This means as an owner of an LLC, you are not personally liable for the obligations of the business. For example, if someone sues your company, they cannot go after your personal assets if you have an LLC in place.
Both an LLC and S-Corp provide you as the business owner: limited liability.
Other similarities between the two are: passed through taxation. This means the business itself does not pay income taxes. But instead, the business profits are passed through to the owners and the applicable taxes are paid at the individual level.
Another similarity is the ability to form partnerships. You can have a single member LLC or a multi-member LLC, and the same is true for an S-Corp. Both give you the opportunity to have partners.
Specific tax differences between the two.
LLC owners are called members. Members are typically paid distributions. For tax purposes, the IRS assumes that all profits made in your LLC has been paid to you as a distribution. Simply put, you will pay taxes on all income made in your LLC. You'll actually pay two types of taxes on your LLC income:
The first being your regular federal and state income taxes.
Remember, the IRS assumes that all of your LLC profit has been paid to you as a distribution. Even if it wasn't you'll owe federal and state income taxes based on that income and any other income you might have earned. The US operates on a marginal tax bracketed system. Meaning the more you make, the higher your tax rate.
The second type of tax you'll pay as an LLC owner is: self-employment tax.
This one hits a lot of business owners unexpectedly because they don't know about it. The self-employment tax rate currently is 15.3%. You might recall when you were an employee of a company, taxes like FICA, or Medicare being withheld from your pay. It was roughly about 7.5% of your income. Your employer also had to pay roughly 7.5% of your income in FICA and Medicare, as well. In total, it was roughly 15% being paid to the government in employment taxes.
As a business owner, the IRS figures: you're both the employer and the employee. And you need to pay us the full 15.3% (that’s how self-employment taxes was born). However, there is a limit to self-employment tax. Currently, it is: $137,700. You only have to pay 15.3% of self-employment tax up to this amount. Any amount higher is taxed at 2.9%.
Here’s an example of an LLC taxed as a sole-proprietorship.
Let's say you own ABC LLC and made profits last year of $100,000. You would pay 15.3% or $15,300 in self-employment tax, in addition to your federal and state income taxes (which is based on your taxable income and tax bracket).
$100,000 (Profit)
You pay $15,300 in Self-employment tax (15.3%)
And, if you had taxable income totaling $70,000, you pay about $11,000 in federal taxes (this does not include your state taxes in total).
As an owner of ABC LLC taxed as a sole-proprietor, you'd pay at least $26,000 in taxes annually, or at least $2,100 per month.
Most business owners see the federal and state income taxes coming (but sometimes forget about the self-employment tax).
So where does S-corp or an LLC taxed as an S-Corp stand in all of this?
Well, to avoid the 15.3% and self employment taxes on all of your LLC profits, many entrepreneurs opt to elect to be treated as an S-Corp. Why? Because S-Corporations don't pay self-employment taxes on distributions to owners. However, they do pay self-employment taxes on the salary paid to owners.
As an S-Corp owner, you must structure yourself as an employee of the business and pay yourself what's called: a reasonable salary. And the self-employment tax is only based on your salary (not the entire profits or distributions of the business, like an LLC).
Some people might take illegal advantage of this and pay themselves a really low salary so self-employment tax is low, and then pay out a really high distribution where self-employment tax is not applicable.
This is why the IRS states: your salary must be reasonable and align with your actual responsibilities of the business. For example, if you're an experienced lawyer and most lawyers in your area make $95,000 annually. It doesn't seem reasonable to only pay yourself $30,000 in salary. Other factors determining a reasonable salary are: experience level, comparable salary, geographic location, economic conditions and more.
Let's go back to our original example of ABC LLC, but this time, taxed as an S-Corp. You make $100,000 in profits. Then, pay yourself $50,000 in reasonable compensation or salary, you only have to pay 15.3% or $7,650 and self-employment tax on $50,000. The other $50,000 would be considered a distribution and not subject to self-employment tax.
$100,000 (Profit)
You pay yourself a reasonable salary of $50,000
Then you pay $7,650 in Self-employment tax (15.3%)
You’ll consider the other $50,000 a distribution which is not subject to self-employment tax.
Compared to the LLC taxed as a sole proprietorship, you would save $7,650 in self employment tax, or $638 monthly in taxes.
Do you see now why one would choose to be taxed as an S-Corp?
In short, S-Corps are able to drastically reduce their self-employment tax obligation by only paying self-employment tax based on their salary and not on their total business income.
How can you determine if S-Corp status is right for you?
First, you have to determine your intent with the profits of your business. If you plan on withdrawing all of your business profits as a distribution, and have no plans of reinvesting those funds back into your business, S-Corp status might be for you.
Second, you should consider if you'll make enough profits in your business. If after paying yourself a reasonable salary, you only have $1,000 left to pay yourself as a distribution, then it's not worth the added effort and paperwork to be treated as an S-Corp.
Paperwork for an S-Corp
If after consulting a competent CPA and you determine that S-Corp status is right for you, then you must file the appropriate IRS forms by March 15th if you want your S-Corp status to be effective in the current tax year. If not, you'll have to wait until the following year for your S-Corp to take effect. There are some compliance requirements of S-Corp which include:
No more than 100 shareholders
It must be a US company
The shareholders must be US residents
Havr only one class of stock
Most small companies easily fall into these categories.
To recap everything, just remember:
Both an LLC and S-Corp provide the same level of limited liability to the business owner.
Both can be considered LLCs
An LLC (taxed as a sole-proprietorships) or general partnerships are taxed on 100% of the company's profits
Owners of such entities pay both federal and state taxes and self employment taxes
S-Corps or LLC (taxed as an S-Corp) only pay self employment tax on their reasonable salary and the rest of the company's profits are treated as a distribution not subject to self employment tax.
If you're thinking about being taxed as an S-Corp, consider what your goals are for the profits you earn in your company; whether or not you plan on reinvesting them or taking it all out as a distribution. If you're taking distributions, then an S-Corp status might be worth it. If you plan on reinvesting your profits another entity type might suit you best. If you're making enough profits then electing to be an S-Corp may be worth it. If after these considerations you decide to be an S-Corp, make sure you file the appropriate forms with the IRS by March 15 for it to take effect in the current tax year.
Remember the compliance requirements to keep your S-Corp status in good standing.