Confused about business designations? LLC vs. S-Corp
Blog By: Attorney Nicole Hetz
Are you a business owner thinking about becoming an LLC or an S Corp? Let me stop you right there. One of the biggest misconceptions our clients have when formalizing their business is that these two things are either/or. An LLC and an S Corp are two different things. One is a legal entity type and the other is a tax election. An LLC is a business entity whereas an S corporation designation is merely a tax choice, (a classification, taxed according to Subchapter S of Chapter 1 of the Internal Revenue Service Code). To simplify, an S corporation might begin as some other business entity, such as a sole proprietorship or an LLC and then elect to become an S corporation for tax purposes.*
You may be wondering, should I become a S Corp? Is this the right time? If you're a sole proprietor, the best next step is to establish an LLC for your business assets to be separated from your personal assets. The smaller, simpler, and more personally managed the business is, the more appropriate the LLC structure is for the owner. You can always change the structure later on when you are ready. An S corporation is generally better for a more complex company with many people involved. This format is preferable if the business is seeking substantial outside financing or if it will eventually issue common stock.
Let’s put this in practice: imagine that, no matter what your area of work is, you, as the sole owner of your LLC, make $100,000 in profit a year. That is pretty good profit! This is the moment you need to ask yourself: am I able to pay myself a reasonable salary? A reasonable salary, in case you tend to undervalue your work, is an amount comparable to someone in your same industry who is doing the work you do.
Let’s say you're a designer and that a reasonable annual salary would be $70,000. Under the default LLC taxation, you’ll pay self-employment taxes on your full $100,000 of profit. Currently, the self-employment tax rate is 15.3%, and you’ll pay this tax on all your profits until you reach the maximum annual Social Security contribution ($142,800 in 2021). But if your business is taxed as an S Corp, you’ll only pay payroll taxes on your reasonable salary of $70,000. The other $30,000 will still be subject to income tax, but not Medicare or Social Security taxes. This is the “famous advantage” of electing to be a S-Corp. The IRS is very aware that some owners of S Corporations have abused this rule by taking advantage of this tax benefit by classifying their own income as zero percent salary and 100% distributions, thereby completely avoiding payroll taxes.
We always advise consulting with a CPA or accountant about the specific additional costs and the income threshold that will justify the tax benefits of an S Corp. You’ll just need to make sure that you are financially ready for this step. If you are just starting your business and don’t know how much income you will generate, we advise you to start as an LLC and see how the business evolves.
If you need to form an LLC or any legal services, please reach out for a 30 minute, no cost service consultation. Our team of experts can help you with your business law needs and help set you up for success.
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*Source: Internal Revenue Service. "S Corporations." Accessed April 20, 2020. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations