Photo by Marcos Paulo Prado on Unsplash
As a small business owner, you’ve probably heard the words LLC and S Corp floating around. And you probably need to decide which one to form. And while legal structures aren’t the most exhilarating topic, picking the right one is essential for your business.
Deciding if you should go LLC or S Corp starts with knowing the differences between the two and how each one will impact your business. Read on to learn everything you need to know about LLCs and S Corps.
LLC vs. S corp: The basics
As a small business owner, the two legal structures you’ve probably heard the most about are single-member LLCs and S Corps. Before we talk about the difference, we got to get one technical thing straight.
Technically, an S corp isn’t a legal entity but a tax election. It’s confusing but bear with us.
The IRS assigns every business structure a default tax treatment...which is just a fancy way of saying that the IRS decides how each business structure is taxed.
Single-member LLCs are automatically taxed like sole proprietors unless they ask otherwise. That’s where the S corp election comes in.
You can ask the IRS to tax your single-member LLC as an S corp, which means that the IRS won't tax you under the rules of a sole proprietorship; they’ll tax you under the rules of an S Corp (which we'll talk about later).
To keep things simple in this article, we will be referring to:
Single-member LLC as an LLC
Single-member LLC electing to be taxed as an S Corp as an S Corp
Taxes
The biggest difference between an LLC and an S Corp is how you’re taxed.
An LLC and S Corp are both pass-through entities. That means that all the profits from the business are passed on to the owner’s tax return. Unlike a C Corp, which has to pay corporate taxes, your business doesn’t pay any taxes. Instead, you, the owner, do.
How LLC taxes work
The IRS automatically taxes an LLC like a sole proprietorship. Under this tax treatment, you’ll pay two types of taxes:
Self-employment tax - 15.3% of 92.35% of your profit. Self-employment tax goes towards your Social Security and Medicare.
Income tax - Varies based on your tax bracket.
You probably know that self-employment tax is a killer, and it’s why taxes feel so much higher when you’re a small business owner than an employee.
When you’re an employee, your employer pays for half of this 15.3% through payroll taxes, and you pay the other half, which is deducted from your paycheck.
When you’re a small business owner, you pay for all of it yourself.
How S Corp taxes work
When it comes to S Corps, there’s one major tax difference: S Corp owners don’t pay self-employment tax on the business’s profits. They only pay income tax on the profits.
It sounds great, we know. But there’s a catch. S Corp owners are required to pay themselves a reasonable compensation via payroll. And your employee wages are subject to FICA payroll taxes.
FICA payroll tax is 15.3% of your employee wages. Yes, that’s the same amount as self-employment tax. But, the difference is that your business pays half of that (7.65%) through employer payroll taxes, and you pay the other half (7.65%), which is deducted from your paycheck.
You pay the equivalent of self-employment tax, but only on your employee earnings.
There are a few other things to know about S Corp taxation:
Your payroll taxes and the salary you pay yourself are a tax write-off, which lowers your taxable profits.
There’s no federal guideline for reasonable compensation, and we recommend chatting with a tax professional about how much to pay yourself (p.s. Collective can help with this!).
You’ll also have federal and state income tax withheld from your paycheck.
Your income tax will include your employee wages and the profits from your S Corp.
Tax savings: LLC vs. S corp
Let’s do an example to compare the taxes a small business owner would pay as an LLC and S Corp. We’re basing this example on a small business owner who earns $150,000 annually in profit and, who as an S Corp, pays themselves a $50,000 salary.
In this example, the business owner could save $15,350 by switching to an S Corp! Keep in mind that these tax numbers don’t include income taxes or state taxes, which will vary based on your tax situation.
If you want a personalized comparison of how much you could save with an S Corp, check out Collective’s tax savings calculator.
Additional costs
S Corps cost more money to run than an LLC. Here are some of the additional costs associated with an S Corp:
Payroll service fees
You 100% don’t want to do manual payroll yourself. Manual payroll involves many percentages, tax calculations, quarterly and annual forms, and ongoing payments to the IRS. If you calculate your payment wrong or miss a deadline, you’ll be subject to a penalty and pay interest on underpayments that you made.
Trust me. It’s way more work than you want to deal with. Instead, you can use a payroll service that runs payroll for you and takes care of all your tax payments and paperwork. Our favorite payroll service is Gusto, which is perfect for S Corp owners.
But like most magical things that do all the work for you, Gusto isn’t free. Gusto will cost you $45 a month to run payroll (unless you have a Collective membership, which includes a free subscription to Gusto).
Bookkeeping costs
The days of doing your bookkeeping via a shoebox full of receipts are over. As an S Corp, you’ll need to get serious about your bookkeeping and use a legit accounting program, like QuickBooks Online. The most basic QuickBooks Online subscription will cost $20 per month (Collective members also receive a free subscription to QuickBooks Online).
Tax preparation fees
When you’re an LLC, you report your business’s income and expenses on your personal tax return, and you only file one tax return.
As an S Corp, you’ll file your personal tax return plus a corporate return called the 1120-S, U.S. Income Tax Return for an S Corporation. Filing this extra return will set you back several hundred dollars.
Annual state registration fees
Depending on where you live, you might have to pay a yearly registration fee for your LLC and S Corp. Fees range from $20- $800 per year.
Cash Flow
S Corps require steady cash flow.
Cash flow is the money that comes in and goes out of your business in a given period. While cash flow includes your income and expenses, it also includes transferring money to your personal account, debt payments, and savings.
Sometimes, businesses are profitable but don’t have enough cash flow to sustain their operations because too much money is going out to cover debt, taxes, or owner pay.
With an S Corp, every time you run payroll, you pay a portion of your taxes in real-time, both as the employer and employee. This means you need to have the money available for your salary and payroll taxes every month.
Liability protection
The good news is when it comes to liability protection S Corps and LLCs offer the same level of limited liability protection to their owners. That’s because an S Corp is an LLC taxed under the rules of an S Corp.
Limited liability means that if your business is sued or can’t pay its debt, creditors and claimants can’t go after your personal assets, like your house or car. While there are some exceptions to this rule, generally, this is the case.
Which one is best for you?
The truth is, the less you earn, the less beneficial an S Corp will be for your taxes. Even if you have some tax savings, the additional costs might eat up all your tax savings. Then you just have more work to do with no payoff.
Our general rule of thumb is that you will benefit from an S Corp if:
You’re earning more than $80,000 in profit each year
You can pay for the additional costs of running an S Corp
You have the cash flow to make regular payroll runs
Now that you have all the deets about LLCs and S Corps, you can make an intentional decision about which entity to form. Still not sure if an S Corp is right for you? Check out Collective’s tax savings calculator and see how much you could save with an S Corp.
C&C readers can enjoy 2 months of a Collective Membership at 50% off with this exclusive sign-up link.
About the Author: Andi Smiles is head of content at Collective. She started her career as a small business financial consultant, teaching businesses-of-one to take control of their finances to build more authentic and sustainable businesses. She’s helped thousands of self-employed folx organize and understand their business finances while also uncovering their emotional relationship with money.
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