Setting up a business can be a confusing process. One must consider a lot of different things, some of which they will have no idea about. For some people, one of these unknown areas may be the business structure itself. There are a lot of ways to set up a business legally, but the two most common legal structures are a Limited Liability Company (LLC) and a Subchapter S-Corporation also known as the “S-Corp. However, for most folks, while they may have heard of these terms, may not know what they mean and more importantly how to tell them apart. In this post, I aim to explain both of them and offer pros and cons of each.
What Do They Have in Common?
Well one thing they have in common is that an LLC can technically be the same entity as an S-Corporation. This is because you can convert your LLC to be taxed as an S-Corporation. Anyways another thing that they have in common is that they create a veil so to speak and protect the personal assets of the members, so they aren’t liable for the debts and operations of the business. Also, they allow partnership business structures. Also, S-Corporations and LLCs are both passthrough entities. This means that income is passed through to the members. This income is taxed at the individual level at personal tax rates. The LLC and S-Corp do not pay taxes directly, at the entity level.
LLCs
A Limited Liability Company or LLC is a business structure allowed by a specific state structure. LLC owners are called “members” and have limited liability in the business itself. This is to say, that they are not personally liable for debts or operations of the LLC itself. LLC’s can also have a single member which would be called a “single member, LLC”. The LLC itself can be taxed as a sole proprietorship, a partnership and even an S-Corporation, which I will talk about later in this article.
An LLC (not taxed as an S-Corporation) does not save on taxes by itself. While it does provide asset protection an LLC doesn’t allow the members to pay themselves. This means that in an LLC your entire net profit (income minus your expenses) is subject to self-employment taxes. These taxes amount to 15.3% of your net profit. Normally in traditional jobs your employer would pay half of the FICA amount and you, the employee would pay the other half.
LLC Tax Example
Here is an example of how the taxes would look. Let’s say you have an LLC that had a net profit of $200,000 then you would have self-employment taxes of $30,600 ($200,000 times .153 or 15.3%). Just for planning purposes this equates to almost $2,500 a month just on self-employment taxes. Not to mention the fact that this income would pass through to the individual members. This means you would also be responsible for federal and state income taxes.
S-Corporations
Like I said earlier in the article LLC’s can be converted and taxed as S-Corporations. The S in S-Corporations comes from subchapter S in the Internal Revenue Code. To be an S-Corporation the entity must meet certain requirements. One of these is unlike LLC Partnerships an S-Corporation can only have 100 members. The main benefit of an S-Corporation is that it offers incorporation while still being taxed like a partnership. Meaning that income is passed through to the owners.
However, tax wise, S-Corporation officers/members can pay themselves a salary and take distributions. Both payment strategies can have huge tax benefits. Distributions are not subject to the 15.3% self-employment tax. However, be aware you are not allowed to just move all your income to distributions and avoid self-employment tax entirely. But when it comes to LLC vs. S-Corp comparisons, it certainly makes the S-Corporation look much more attractive. Now regarding the salary, the IRS clearly states that you must take a “reasonable salary”. What the IRS means by “reasonable” however is subjective. But luckily for you here is an article with possible guidelines for helping you choose a “reasonable” salary.
S-Corporation Tax Example
Now let’s look at the tax situation for an S-Corporation making $200,000. For this S-Corporation we are saying that the owner will take a $80,000 yearly salary and that this is reasonable. This means that instead of the full $200,000 being subject to self-employment taxes only $120,000 will. This means that instead of paying $30,600 in self-employment taxes like the LLC you are only paying $18,360 (120,000 times .153 or 15.3%). This is a tax savings of $12,240. That’s nearly $1,000 a month less than the LLC example.
Conclusion
In summary starting either an LLC or an S-Corporation is a great idea. Both LLC’s and S-Corporations provide a lot of legal protection benefits and passthrough income benefits. Both entities allow for owners to not be double taxed. However, if you qualify for S-Corporation election you can potentially save on self-employment taxes. So, in the comparison of an LLC vs. S-Corp it’s all about what your specific business is about and if you’re willing to jump through some hoops for potential tax savings. As always be sure to consult with your personal CPA/accountant that can better give you advice on your unique tax situation.