Should you be taxed as an LLC or S-Corp? This is a critical question for business owners to consider, but unfortunately, it can get confusing.
Here’s why: an S-corp can be an LLC, but not all LLCs are S-corps.
What!?! Don’t worry, everything will be explained below. Making the right choice can substantially reduce your tax bill, while the wrong choice can cost you a lot of time and money. Because of that, it’s critical to understand the pros and cons of both options.
To help you out, this post looks at the differences between an LLC vs S-corp, and then it talks about the LLC tax benefits compared to S-Corp tax benefits. Finally, it helps you figure out which is the best option for your unique business and explains why you should consult with a tax pro.
Keep reading to learn the following:
Table of Contents
What Is an S-Corp?
An S-corporation is a special tax status granted by the IRS. It’s not a legal business structure like an LLC. However, your business must first be organized as an LLC or a C-corporation before you can elect S-corp tax status with the IRS.
When you compare an LLC vs. S-corp, you’re really talking about an LLC taxed as an S-corp compared to an LLC that’s not taxed as an S-corp.
The IRS considers normal LLCs as disregarded entities. This is just a fancy way of saying that the IRS sees you and your business as the same entity. All of your business income flows to you personally, and you pay tax on all of that income.
With an LLC, you normally pay yourself with distributions. You don’t have to put yourself on payroll. In contrast, with an S-corp, owners who provide services to the business are on payroll, and their salary is subject to payroll taxes. While it may sound surprising, this actually lowers your total tax bill.
To benefit from this strategy, S-corp owners must pay themselves a reasonable salary. Then, they can take the remaining profits as a distribution. The following section explains how this reduces your tax bill.
S-Corp Tax Benefits
For most taxpayers, the biggest benefit of a S-corp is that it can reduce your self-employment tax. This applies to sole proprietors and partnerships with pass-through income.
If your business is a C-corp, you can use an S-corp election to avoid double taxation on corporate profits. C-corps generally face double taxation, once at the business level and again when dividends are distributed to shareholders. However, as long as you have 100 or fewer shareholders, you can avoid this by requesting to be taxed as an S-corp.
Keep reading for more details about S-corp tax benefits.
How an S-Corp Can Reduce Self-Employment Taxes
If you elect to be taxed as an S-corp, you don’t have to pay self-employment taxes on all of your profits. In contrast, if you are taxed as a sole prop or partnership, all of your profits will be subject to self-employment tax. As of 2023, the self-employment tax is 15.3%, so the savings can add up quickly.
For instance, if you earn $150,000 in business income, you will pay about $23,000 in self-employment taxes. On top of that, you will also have to pay federal and state income taxes (unless you live in one of the six states that don’t have income taxes).
Depending on how much your business earns, you can save tens of thousands of dollars by reducing your self-employment taxes. However, to do this correctly, you must understand the purpose of these taxes and the IRS rules for S-corps.
The purpose of self-employment taxes is to fund Social Security and Medicare, and the 15.3% self-employment tax consists of a 12.4% tax to cover Social Security and a 2.9% tax for Medicare.
In a traditional employer-employee relationship, the employee pays 7.65% of their income in Social Security and Medicare taxes, and the employer pays a matching amount. Together, these two payments make up 15.3%. When you own a normal LLC, you are considered to be “self-employed,” and thus, you pay both the employee’s and the employer’s portion of the tax.
In contrast, when you elect to be taxed as an S-corp, you are not considered to be “self-employed,” and thus, you don’t have to pay self-employment tax. Instead, the S-corp pays you a reasonable salary for the work you do.
Then, you, as the employee, pay the 7.65% Medicare/Social Security tax on your wages, and the S-corp, as your employer, matches the 7.65% tax. Now, as long as your “reasonable compensation” is less than your overall business income, you pay less tax overall.
Example of S-Corp Vs. Sole Prop Taxation
Here’s a simple example to show how that works:
As indicated earlier, if you earn $150,000 in income and you are not a corporation, you will pay about $23,000 in self-employment tax. Now, let’s see what happens if you elect to be taxed as an S-corp and you pay yourself a $60,000 salary.
Your $60,000 salary will be subject to the 15.3% self-employment tax. That reduces your self-employment tax to $9,000. Then, the remaining $90,000 will come to you as business profits, and you will incur income tax as usual on that amount. This strategy saves you $14,000, and as your profits grow, you will save even more money.
Drawbacks of S-Corp
The main drawbacks of an S-corp are the additional costs, time, and tax compliance issues. S-corps also have limits on some tax deductions.
While the benefits of S-corp taxation are clear, it’s not the right decision for every business. Before you decide, you need to be aware of the following:
Running an S-Corps will cost you a bit more money than a sole prop or a partnership. As an S-Corp, you will have to pay for the following:
- An S-corp tax return — This is typically more expensive than a non-corporate return
- Payroll software subscription — This may cost a few hundred dollars per year
- Payroll taxes — In addition to self-employment tax, you may need to pay other local taxes and unemployment insurance
- State franchise taxes — Depending on your state, they may apply a franchise tax to your S-corp
Also, keep in mind that your time is also an expense. The time you spend setting up your S-corp, running payroll, or making sure that you are compliant, could be spent on growing your business. Before you make this election, make sure the tax savings are worth the extra time and money, and work with a CPA firm to simplify or automate the process for you.
The second major drawback of S-corporations is the additional rules. S-corps are subject to more stringent rules than LLCs. If you elect to be taxed as an S-corp, you will need to deal with the following:
- Paying yourself a “reasonable” salary — realize the IRS can challenge the concept of reasonable
- Setting up payroll, which includes making tax deposits and filing payroll tax returns
- Filing a standalone S-corp tax return in addition to your personal tax return
- Identifying each shareholder’s basis on the S-corp return
- Holding annual board meetings with other shareholders, if applicable
- Ensuring you never have more than 100 shareholders
- Keeping minutes at the board meetings
If this list stresses you out, this may not be the best option for you. Be aware, however, that these expectations sound a lot more daunting than they are, and a CPA can help you deal with most of these issues.
Limits on Certain Tax Deductions
The third major drawback of an S-corp is that it can limit other deductions you may have. Since you are required to take a salary as an S-corp, any deduction based on your salary may be limited if your salary is less than your business profits, which is normally the case.
This is particularly true in relation to retirement contribution deductions. For example, a SEP IRA is a self-employed retirement plan that allows you to contribute up to 25% of your income and receive a tax deduction.
For example, if your non-S-corp business earned $150,000 in income, then hypothetically, you could contribute $37,500 as an LLC. In contrast, if you are an S-Corp and your salary is $60,000, then you would only be able to contribute $15,000. To put it another way, you’ve lost a $22,500 deduction and reduced the amount you could contribute to your retirement plan.
There are also limitations on hiring your kids. With a normal LLC, you can hire your minor children as employees without paying any Social Security and Medicare taxes. But as an S-corporation, if you hire your kids as employees, you would have to pay these types of taxes.
These tend to be the two most common examples, but there are other issues. To ensure you’re making the right decision, you cannot just consider the potential savings on self-employment taxes. Instead, you must consider every aspect of your unique business situation.
To learn more, read the 15 Major Disadvantages of S Corps.
Now let’s talk about the alternative, LLCs.
Misconceptions of LLC Tax Benefits
There are a lot of misconceptions about LLCs, and they often revolve around taxes. Many people think that LLCs are what millionaires and entrepreneurs use to lower their tax liabilities, but that isn’t the case.
An LLC is not a tax loophole. In fact, LLCs have nothing to do with your taxes, in general. LLCs are legal entities that protect you from personal liability in the event of a lawsuit. For example, if someone sues your LLC for damages, the lawsuit should generally only apply to your business, not to you personally. Similarly, if an LLC defaults on a loan, the lender cannot go after the business owner personally unless they personally guaranteed the loan.
For tax purposes, your LLC is viewed as a sole proprietorship or partnership if you do not elect S-Corp status.
LLC Tax Benefits
The main tax benefits of LLCs are related to its ability to:
- Receive pass-through taxation treatment
- Maximize tax deductions
- Take QBI tax deductions
- Elect S-Corp status
- Be set up easily
Because an LLC is a legal entity, it enjoys the same tax benefits of Sole Proprietors and Partnerships, with the exception of electing S-Corp status.
Keep reading to learn more about each tax benefit.
Tax Benefit #1: Pass-through taxation
Pass-through taxation means that all of your business profits are subject to taxation once on your individual return.
The alternative is double taxation.
Double-taxation means that, technically, you are taxed twice – first of all, your business is taxed on all of its profits. And secondly, when you are paid, you are also taxed on income that you take out of your business.
With that being said, a major tax benefit of LLCs is that it is only taxed once with pass-through taxation. Here’s an example:
Let’s say you make $100,000 as an LLC. If your tax rate is 25%, then you would only pay $25,000.00 in taxes as an LLC.
In comparison, imagine you’re a C-corporation. If you make $100,000 as a C-corporation, your business would be taxed on that income first. If the corporate tax rate is 21%, then you would pay $21,000 in taxes. But then, on top of that, you have to pay taxes on what you pay yourself from your corporation. Let’s say you pay yourself $50,000.00 in W-2 wages, and this puts you in a 25% tax bracket. This would mean you would have to pay an additional $12,500.00 in taxes.
So, in summary, as a C Corporation, you would pay $33,500 in taxes, whereas, with an LLC, you would only pay $25,000 in taxes.
Note that this is an oversimplified example and there are additional things to consider, like the self-employment tax, for example. However, in general, this is an example of how someone could view an LLC as a tax benefit.
Tax Benefit #2: Tax Write-Offs
Tax write-offs are another significant benefit of becoming an LLC. As a self-employed individual, you can write off eligible business expenses like home office expenses, business travel, and other necessary and ordinary expenses for your business. You can also take an above-the-line deduction for health insurance premiums.
To ensure you don’t miss any write-offs, you should consider separating your personal and business finances. For example, if you have a business bank account, you can sync your financial information with a bookkeeping platform like QuickBooks. Then, you can categorize all of your business transactions so you can easily start deducting eligible expenses from your tax return.
Tax Benefit #3: Pass-through Tax Deductions
LLCs that are taxed as pass-through entities (rather than S-corps) can also claim a 20% pass-through tax deduction.
Part of the Tax Cuts and Jobs Act (TCJA), this rule allows qualifying pass-through owners to deduct up to 20% of their business income from their taxable income. For example, if you were reporting $100,000 in business income on your tax return, this deduction would reduce your taxable income to $80,000. This could save you thousands of dollars on your business tax return.
There are a few additional rules and regulations that may disqualify you from receiving this tax deduction. However, if you are eligible for it, it could turn into some good tax savings.
Tax Benefit #4: S-Corporation Election
Another tax benefit of LLCs is that you can elect to be taxed as an S-corporation. When you make this election, you reap all of the legal benefits of being an LLC along with the tax benefits of being an S-corp. However, you must consider the drawbacks of S-corps.
Tax Benefit #5: LLCs are Easy to Set-Up
One of the best things about LLCs is that it is fairly easy to set up, which ultimately makes filing your taxes much easier and less stressful than other entity types.
LLCs have fewer compliance requirements than other tax entities. With an LLC, you don’t have to worry about divvying up stuff like common stock and preferred stock. And, there is less record-keeping required for setting up your LLC.
When to Switch Your LLC to an S-Corp
The best time to switch your LLC to an S-Corp is when the benefits of the S-Corp outweigh the drawbacks.
Or in other words, you should become an S-corp when it will save you more money than it costs you in money, time, and other efforts. The more money your business earns that is subject to self-employment taxes, the more likely you are to benefit from switching to an S-Corp versus staying in an LLC.
The general rule of thumb that a lot of people subscribe to, is to elect S-corp status once your business income exceeds $40,000 per year. At this income level, you should be able to shave off about $6,000 in self-employment taxes, but you will incur about $2,000 to $3,000 in payroll taxes plus the costs for the additional tax returns.
That’s getting close to the breakeven point for most businesses. Again, however, you need to consider if you’re missing any deductions that could lower your overall tax burden and make an S-corp unnecessary. Because of that, the general rule of thumb may not be right for you, and in fact, a lot of CPAs don’t recommend an S-corp until you get to $75,000 to $100,000 per year.
But it’s not a decision you can just make on profits alone. You have to consider all of the unique factors related to your business. The decision could be even more complex if you already have W-2 income, multiple business partners, or other unique circumstances going on.
That’s why we always recommend getting a tax professional involved when making decisions like this. These decisions can result in thousands of dollars in tax savings or thousands of headaches.