LLC vs S Corp – The Best Option for Sole Proprietorships
Many budding entrepreneurs structure their businesses as sole proprietorships. This is the simplest way to get started, but the potential for liability problems creates a serious drawback. If you’re a sole proprietorship, then legally you are the business. If a client sues you for some reason, they’re suing you — not your business. This makes personal assets like your car or your home fair game.
In order to give yourself some liability protection and shield your personal assets, it’s best to structure your business as a limited liability company (LLC) or an S corp. In doing so, your business becomes its own legal entity separate and apart from you. A lawsuit may result in your business losing its assets, but your personal assets are off the table and protected. Both an LLC and an S corp limit your liability, but they get taxed quite differently.
LLC vs S Corp Quick Overview
Technically, an LLC is a business structure and an S corporation is a tax status. An LLC functions as a sole proprietorship. You run your business all year and then pay self employment taxes on your business profits at tax time. An S corporation, however, treats business owners as employees who get a weekly paycheck, complete with payroll tax deductions. This eliminates the need for self employment tax.
Because an S corp treats you as an employee, you get the added benefit of establishing a 401(k) if you wish. There are, of course, rules about how much you can contribute each year. Still, a 401(k) may help you accelerate your retirement savings depending on your situation.
These basics are good to know, but they don’t tell the whole story. There are a few more nuances that mark the difference between S corp and LLC that you need to know.
How an LLC is Taxed
If you’ve been operating your business as a sole proprietor, you’re probably already familiar with LLC taxation. The rules for these two entities are the same. As an LLC, you will run your business throughout the year, making estimated income tax payments as required. At the end of the year, you pay tax on your business profits. You also pay self employment tax.
The reason why you pay a self employment tax is that you have no employer to match your payroll taxes for you. Typically, you pay half of your Medicare and Social Security tax and your employer pays the other half. Without an employer, you become responsible for the entire tax. This is what you pay at the end of the year when you pay self employment taxes.
How an S Corp is Taxed
If you wish, you can ask the IRS to treat your LLC more like a corporation. In this case, you won’t have to start paying any corporate taxes, but you will have payroll taxes. Here’s how it works:
When talking the S corp option, your business must treat you as an employee for tax purposes. The IRS requires those in an S corporation to receive a reasonable salary throughout the year. Each paycheck will contain all of the usual and necessary tax deductions.
At the end of the year, you will need to look at two tax categories. You won’t have to pay any self employment taxes, but you will pay income tax on your earnings as usual. You will also pay tax on the profits from your S corp. You can, of course, also claim the loss if your S corp failed to make a profit.
Is an LLC or S Corp Better for Entrepreneurs?
The decision to go S corporation vs LLC is a difficult one with no hard and fast answers. It’s really about trying to figure out what’s best for your tax picture while juggling business size and practicality. The practicality aspect requires you to know yourself. Are you able to set aside money throughout the year so you have it come tax time? If not, you may want to opt for an S corp so that your income tax gets paid via payroll deductions throughout the year. If your financial savvy is on point, you may wish to go LLC so you can pull your own financial strings throughout the year.
Size also matters. An LLC can have an unlimited number of partners and business owners. The size and scope of your business structure aren’t limited. An S corp is capped at 100 shareholders, however. If your company already has many shareholders or you plan to expand, you should probably stick to an LLC.
You will also, of course, look at your tax picture when deciding to be an LLC vs an S corp. Tax experts usually recommend that the threshold for changing from an LLC to an S corp is around $40,000 to $60,000. Once you start making that or more each year, becoming an S corp will likely have tax benefits.
Because the IRS taxes dividends at a lower rate than income, being taxed as an S corp can save you a lot of money come tax time. The possible tax savings are twofold. For one, if you can replace part of your income with dividends, you can pay less tax. Further, since an S corp incurs payroll and payroll tax expenses, there is less profit for you to pay tax on.
In some cases, however, your income and self employment tax combined may be less than the taxes you pay on your income and dividends. In that case, it serves you best to remain an LLC. The only way to know for sure is to run the numbers and assess your individual situation. This is a task best left to an accountant, although it’s possible to work it out yourself.
When choosing your status, be aware that it costs more money to operate an S corp than an LLC. Because an S corp requires a payroll, you may incur payroll service fees as well as income tax liabilities. If operating as an S corp, your business will have to match what your employees pay for Social Security and Medicare tax and pay FUTA taxes. Some states may also charge S corps unemployment taxes. All of these extra expenses also lead to extra bookkeeping, which can cost you time if you do the books and money if someone else does.
Your location may also make a difference. In this article, we’ve focused on your federal taxes. Remember that your state and local governments may also tax you and your business. How they do so and at what tax rates will impact your taxes. Make sure you look at your entire tax picture before making a decision. (Did we mention that this is a good time to call an accountant?)
Should I Have my LLC Taxed as an S Corp?
As we’ve seen, the choice between LLC and S corp is one that varies from one business to another. There is no one-size-fits-all approach, and you will need to look at your individual circumstances.
The good news is, you can change your mind if things aren’t working out as planned. If you have elected to enjoy S corp vs LLC tax benefits, you can change your mind later. You may go back to being taxed as an LLC after taking the S corp classification. To do so you must write a letter of S corp status revocation to the IRS and file an IRS Form 8832.
Note too that you can’t bounce back and forth between LLC and S corp at will. In general, the IRS requires you to stick to an election for at least 60 months (5 years) once you make it. This means that if you opt to go from an LLC to an S corp, you must remain an S corp for 5 years. If you then choose to go back to being an LLC, you must wait another 5 years before you can opt to be taxed as an S corp again.
Changing from an LLC to an S corp and then back again also involves various state filings and fees. As such, you don’t want to be changing your status often. It’s generally best to start as an LLC and then switch to an S corp as your business grows. The smaller and simpler the business, the more likely the LLC designation will serve.
How to Choose the S Corp Designation
If you do decide that an S corp is the right way to go for your business, you’ll need to take a few steps. First, you’ll need to create a business entity — most likely an LLC. You do so by registering your business with your state, which is a process that varies greatly from one place to another. Fortunately, an attorney can help you with this or likely has already if your business is currently operating.
Next, verify that your company is eligible for S corp status. To qualify, you need to be a domestic US company with no more than 100 shareholders. If you’ve issued stock, you may only have one class of it.
If you’re eligible and ready to proceed, file IRS Form 2553 to make the S corp election with the federal government. Once you have, you’ll want to put another call into your lawyer to see if your state has any S corp filing requirements. New Jersey, for example, requires businesses choosing the S corp designated to file the state’s Form CBT-2553. California, however, does not recognize the S corp designation and does not require you to file any state paperwork.
In order for your request to apply for S corp status to apply to the current tax year, the IRS requires you to file it no later than two months and 15 days after the tax year begins. This makes the deadline around March 15 of each calendar year, give or take a few days. If you file your paperwork too late, your S corp tax treatment may not begin until the year after you file. If you filed in June of 2020 for example, your S corp status wouldn’t take effect until the 2021 tax year.
Get Help From A Pro
The decision to operate as an LLC or an S corporation is not an easy one, and it’s one you may have to visit more than once. As your business changes, so might the taxation status that works best for both you personally and the business entity. Because an S corp election impacts so many facets of your business, it’s wise to consult one of the knowledgeable CPAs at Picnic Tax when you’re making your decision. As always, they’re qualified to help you and eager to do so. Let us know if you need help determining whether or not now is the time to make the move to S corp status.