Here’s a question I get all of the time.
And that is: Should I be an S-Corp or an LLC?
If you find yourself overwhelmed or confused with choosing between the 2. Then this post is for you.
I just saved one of my clients over $95,000 in tax expenses from making a simple entity change from an LLC to an S-Corp.
We found out that they have been overpaying in taxes for years.
And here’s the kicker, if they would have chosen the right entity to start with, they’d have hundreds of thousands in tax dollars in their pocket.
Businesses are overpaying in taxes every single year because of the entity they are choosing, and it’s because most people aren’t analyzing the tax consequences associated with the entities they select.
Heck, 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.
So today, I am going to put an end to this and help you choose between an LLC or S-Corporation for your business.
Today, I am going to break down the similarities and differences between an LLC vs an S Corp, especially the tax differences and what you could expect to pay in taxes with each type.
I’ll also include some easy to follow examples of the taxes paid by an LLC and an S-Corp.
I’ll also outline the compliance requirements and how you can decide which one is best for your business.
I have personally helped small businesses literally save thousands of dollars by legally avoiding overpaying in taxes by choosing the right entity.
Now to be fair, I am not a lawyer and am not giving you any legal advice. But I am a licensed CPA and I will break down the gist of the legal jargon and especially focus on the tax items so you can avoid paying too much in taxes.
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 (if not the biggest) expenses you’d have!
Besides the tax implications of an LLC vs an S Corp, there are legal considerations.
All of which and more I am going to explain to you in this post!
Sound good? Ok, let’s dive in!
Importance of Choosing the Right Entity Type
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.
For one, 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 and choosing the right entity is key.
Now, if you want to know if you should be an LLC or an S-Corp, you first need to have a very clear understanding of what each is.
First, let’s start with 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 2 are:
- Pass-through taxation. Meaning the business itself does not pay income taxes and 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 single-member Scorp/ LLCs or multi-member Scorp/LLCs
- Both give you the opportunity to have partners.
Now, let’s get into some specific tax differences of both:
LLC owners are called members and members are typically paid distributions.
For tax purposes, the IRS assumes that ALL profits made in your LLC have been paid to you as a distribution.
Simply put? You will pay taxes on all income made in your LLC.
And you’ll actually pay 2 types of taxes on your LLC income.
Types of Taxes Paid By LLCs
1. 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. And you’ll owe Federal and state income taxes based on that income and any other income you might’ve earned.
The US operates on a marginal tax bracketed system. Meaning, the more you make, the higher your tax rate.
2. 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 is currently 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 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.
Well as a business owner, the IRS figures, well hey, you’re both the employer and the employee and need to pay us the full 15.3%. And their self-employment taxes were born.
There is a limit, however, to self-employment tax and currently, it is $137,700. So you only have to pay 15.3% of SE tax up to this amount.
Any amount higher is taxed at 2.9%.
LLC Tax Example
Let’s look at 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 are based on your taxable income and tax bracket.
So if you had taxable income totaling $70,000, you’d 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. I can’t say the same is true for self-employment tax.
So where does the S-Corp or LLC taxed as an S-Corp stand in all of this?
Well to avoid the 15.3% in self-employment tax on all of your LLC profits, many entrepreneurs opt to elect to be treated as an S-Corporation.
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.
You see, as an S-corporation owner, you MUST structure yourself as an employee of the business and pay yourself a reasonable salary.
And the self-employment tax is only based on your salary. Not the entire profits or distributions of the business like in an LLC situation.
Some people take illegal advantage of this and pay themselves a really low salary (so SE tax is low) and pay out a really high distribution where SE 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, etc
S Corp Tax Example
Let’s go back to our original example with ABC, LLC but this time, taxed as an S-Corporation
If you were to pay yourself $50,000 in reasonable compensation (or salary), you’d only have to pay 15.3% (or $7,650) in SE tax on $50,000.
The other $50,000 would be considered a distribution and NOT subject to SE tax.
Compared to the LLC taxed as a sole proprietorship, you would save $7,650 in SE 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 SE tax obligation by only paying SE tax based on their salary and not on their total business income.
Is S Corp Right For You?
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 have only $1,000 to pay yourself as a distribution, it’s not worth added effort and paperwork to be treated as an S-Corp.
And speaking of paperwork… if after consulting a competent CPA, you decide that S-Corp status is right 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 not, you’ll have to wait until the following year for your S-Corp to take effect.
There are some more compliance requirements of S-Corps which include:
- No more than 100 shareholders
- It must be a US company
- The shareholders must US residents
- Only 1 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 owners and both can be considered LLCs.
- LLC’s taxed as sole proprietorships or general partnerships, are taxed on 100% of the companies’ profits. And owners of such entities pay both Federal/State taxes and self employment taxes.
- S Corps (or LLCs taxed as S Corporations) only pay SE tax on their reasonable salary and the rest of company profits are treated as distributions not subject to SE tax.
- If you’re thinking about being taxed as an S corp, consider what your goals are for the profits earned (whether you plan on reinvesting them or taking it all as a distribution)
- If you’re taking distributions, S-corp status might be worth it. If reinvesting, another entity type might suit you best.
- Also consider if you’re making enough profits. If not, electing to be an S corp may not 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 15th for it to take effect in the current tax year.
- Also keep in mind the compliance requirements to keep your S corp status in good standing.
I hope you learned a lot of valuable information in this post. If you need more help with your financial needs or with your business taxes, our team of tax experts got you covered. Contact us today!