Many new business owners spend days and even weeks struggling to come up with the ideal business name. They want something that connects with their target market and, at the same time, clearly describes what their business is about.
But not many of them spend as much time thinking about the legal structure of their business. And this is one decision that can shape how much they pay in taxes, as well as the overall financial and legal health of the business.
No wonder only about half of founders (48%) in a survey cited by the Entrepreneur feel confident that they’re handling their business taxes correctly. Others worry about overpaying or missing deadlines. This clearly shows how important choosing the right structure is.
When it comes to making this choice, it mostly boils down to two options: LLC vs S Corp. On the surface, they both look very similar. But in reality, the difference can be pretty significant, especially in terms of tax savings.
So, what exactly are LLCs and S Corps? And more importantly, which one can save you more money on taxes?
Let’s break it down.
What is an LLC?
An LLC, or a limited liability company, is basically a business structure designed to protect your personal assets as a company owner or founder. You have a business that operates and everything, but if things go wrong with the company and you get sued, your personal assets stay yours.
Here’s where it gets interesting for taxes. If you’re the only owner or sole proprietor, the IRS treats your LLC like it doesn’t even exist. You report everything on your personal tax returns using what is known as a Schedule C. LLCs with multiple owners get treated like partnerships.
The main benefit is very simple. You don’t have to run payroll, file separate corporate tax returns, or jump through a lot of hoops. You just report the business income on your personal tax return.
What is an S Corp?
An S Corp, or S Corporation, isn’t really a separate business structure. Nope. Rather, it’s a tax election that lets the IRS know to treat your business like a partnership for tax purposes. Why? So you avoid the double taxation that usually hits regular corporations.
In an S Corp, the owners are called shareholders. However, you’re technically an employee of your business, which means you have to pay yourself a reasonable salary.
The good thing about the S Corp system is that the company’s profits, losses, deductions, and credits pass straight through to you and are taxed at your personal level on your 1040. No corporate-level tax in between.
To qualify as an S Corp, your business first has to be registered as either a C corporation or an LLC. You’ll also need to submit the S Corp election, also known as Form 2553.
Differences Between an LLC and an S Corp
Now, let’s take things further by breaking down the key differences between LLC vs S Corp.
Taxes
The tax difference is primarily the key reason businesses choose between LLC and S Corp. First of all, the self-employment tax in the U.S. is 15.3%. This divides into 12.4% for Social Security and 2.9% for Medicare.
As an LLC, you’re expected to pay this self-employment tax on all your profits. For an S Corp, you pay payroll taxes on your salary only. The rest ranks as a distribution, which helps you avoid self-employment tax.
Let’s do a quick example that most tax pros use. If your business nets $100,000, at 15.3%, you’re looking at roughly $15,300 in self-employment tax as an LLC. When you operate an S corp, and you pay yourself a reasonable salary of $60,000, with $40,000 as distributions, you’d pay about $9,180 in payroll taxes. That’s a savings of over $6,000 a year.
The catch? You must justify the ‘reasonable salary’ to the IRS. If they think it’s too low, they could reclassify your distributions and come after you with back taxes.
Management and Paperwork
The simple truth is that LLCs are low-maintenance. You can operate pretty casually. S Corps, on the other hand, require more structure: corporate minutes, payroll processing, separate business accounts, and so on. It may not be exactly overwhelming, but it’s real work.
Ownership Rules
S Corps come with restrictions. For example, you can’t have more than 100 shareholders, and they all have to be U.S. citizens or residents. LLCs don’t have such limits.
Compliance Costs
Running payroll for an S Corp isn’t exactly the same as running payroll for an LLC. Because of the way things are structured, you’ll likely need payroll software or a tax pro to help keep everything compliant. You have to figure in the likely costs for these extra administrative tasks.
Want the full rundown on all the differences? Click here to check out our detailed guide. It covers everything you need to know to decide between LLC vs S Corp.
LLC vs S Corp: Which Should You Choose?
Now that you know the differences between LLCs and S Corps, which one is good for your business? Here’s what to know.
If you’re just starting out or your profit is still quite modest, the simpler LLC is better for you. It means less paperwork, easier bookkeeping, and fewer compliance headaches. A freelancer making $30,000 per year will definitely not get much benefit from S Corp payroll rules.
An S Corp, on the other hand, starts to pay off when your business starts netting around $60,000 or more. So, paying yourself a reasonable salary and taking distributions at this stage of your business can save thousands in self-employment taxes.
So, which should you choose? As Doola puts it, it all comes down to which of them suits the needs of your current predicament.
Bottom line? Choose the system that fits what’s coming into your business and how willing you are to handle extra paperwork.
Final Thoughts
Here’s what you should keep in mind: the LLC vs S Corp question isn’t about which is “better.” It’s about which is better for you, right now, at your current income level. That answer might change as your business grows, and that’s perfectly fine.
So, before you make a concrete decision, calculate your potential savings or better still, talk to a pro. Only make the move when it makes sense. Your business will thank you when tax season rolls around.
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