Determining whether or not your business should file as an LLC or an S corp can be difficult. First and foremost, it’s important to understand the fundamental differences between the two. Then, you can weigh your options and make an educated decision. Here are some differences between LLCs and S corps and tips on how to choose the right designation.
What is an LLC?
A limited liability company (LLC) is a business entity that is legally separate from its owners, who are known as ‘members’. It’s important to note that the exact definition of LLC will vary from state to state, but by and large, it’s roughly the same everywhere. Many business owners choose to form an LLC over a corporation because LLCs offer more flexibility.
This helps with bookkeeping since the way they are managed leads to fewer recordkeeping and reporting obligations. It also provides more liability protection than an individual ownership. It’s not uncommon for people to use LLCs to hold assets such as real estate, vehicles, boats, or aircraft.
What is an S Corporation?
An S corporation is a type of corporation that meets specific IRS requirements. Much like an LLC, S corps provide protection from the creditors of your business. You can’t be financially responsible for more than your investment in the company.
Both LLCs and S corps can deduct pre-tax expenses such as travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and more. When it comes to S corps, the corporation itself is not subject to federal income tax. Instead, the shareholders are taxed upon their allocated share of the income.
What are the Differences?
The major difference between LLCs and S corps is how each one pays taxes. As a default LLC, all company profits pass through the owners’ personal tax returns. The owner must then pay income tax and self-employment tax on the entire amount.
As an S corp, owners pay income tax and self-employment tax on a predetermined salary. Only profit distributions are subject to income tax. Most small businesses choose to file taxes under the default LLC classification because most don’t usually carry the amount of profit required to make the S corp designation beneficial.
Single-Member LLC Taxed as a Sole Proprietorship
If you are a single-member LLC and you decide to file as a sole proprietorship, you must report business income and expenses on your personal income tax return. You must then pay personal income tax on any company profit. Since you are considered self-employed, you are responsible for paying Social Security and Medicare taxes on your profits.
Self-employed individuals pay a 12.4% Social Security tax on the first $118,500 of income, and a 2.9% Medicare tax on all income. Higher earners will have to pay an additional .9% Medicare tax. Your employees are subject to the same taxes, but you must pay half and the employee must pay half.
Single-Member LLC Taxed as an S Corporation
As an S corporation, a member (or owner) can be considered an employee of the business. This can help you tremendously when it comes to paying your taxes. As an owner-employee, you must be paid a reasonable salary.
The LLC will report the salary as a business expense, and you will report both the salary and the remaining business profit on your tax return. So, for example, let’s say your business makes a $250,000 profit, and you determine your reasonable salary is $100,000. Your salary will be labeled as a business expense so your company now has a $150,000 profit. This means you and your business will only pay Social Security and Medicare taxes on your $100,000 salary.
Choosing to file as an S corporation can be a slippery slope. There have been many instances where members have failed to give themselves a reasonable salary, leading to legal action being made by the IRS. Because of people taking advantage of the system, S corps are subject to increased scrutiny by the IRS.
A reasonable salary is any salary that you would pay someone to do the same job. The best way to determine what your reasonable salary should be is by comparing similar salaries in your industry.
IRS S Corporation Requirements
It’s important to note that not every small business will meet the IRS’s requirements. The IRS requires that businesses that elect the S corp status have 100 shareholders or less. These businesses are only allowed to issue one class of stock.
On top of that, the owners of the business must be US citizens or permanent resident aliens. Owners must be private individuals and not other business entities such as LLCs, corps, or trusts. By meeting these requirements, your business may elect the S corp status. This will help big time when it’s time to pay taxes.
Should You File as an S Corporation?
Your decision is going to largely depend on how much profit your business is going to earn and carry-over from tax year to tax year. If you know your business will bring in a profit larger than $10,000, even after paying yourself a reasonable salary, then your business has enough profit to justify becoming an S corp.
If you’re unsure how much profit you will make, or you want to reinvest the profits back into the company, it may be best to remain in the default LLC classification. Many business owners will put profit back into their businesses to promote growth. Keep in mind, you can always apply to change statuses if the needs of your business change.
We’re Here to Help
We know that trying to decide whether or not you should classify your business as an LLC or an S corp can be difficult. We also know how confusing some of the intricacies of the filing process can be. That’s why our team here at the Tax Crisis Institute is here to help. We offer a wide range of services designed to help you when it comes time to file taxes. Give us a call to find out how we can help.