Figuring out the difference between an LLC vs S Corp can be tough. And each decision comes with a different tax liability which effects your bottom line.
To wrap up this month’s theme of making my biz legit, I’m explaining exactly WHY I chose to be an LLC and NOT be taxed as an S Corp — even though I could save money on taxes.
You’re probably thinking that I’m a bit crazy for doing this, but take a moment to hear my reasons why! This was obviously a personal decision, but I want to share the pros and cons with you.
If you’re wondering whether or not your business should become an LLC versus an S Corp, I’m breaking down the tax benefits and costs for how to choose the best small business entity.
FYI: None of this is meant as actual tax advice for how YOU should do things. This is just to describe to my personal thought process when I was making the decision for MY business.
What it really means to be an LLC
For tax purposes, an LLC is considered a “pass through” entity where all of the income and expenses by the business pass through to your personal tax return.
In other words, all of income and business expenses get reported on a Schedule C that’s filed along with your income tax return at the end of the year. In most cases this is referred to as a single-member LLC.
Here’s a real-life example of being taxed as an LLC.
I’m a single-member LLC which means I’m still subject to regular self-employment tax — until I decide to become taxed as an S Corp at some point in the future.
This means that my income tax bracket is 12% MFJ (Married Filing Joint) with the 15.3% SE tax. Since I live in Colorado I also have to pay a 4.63% state tax. All of this together comes to a total of 31.93% owed for taxes every year.
Because of this, I round down the amount I set aside for taxes to 30% so I can be sure that I’m saving enough. Obviously, I also get back a portion of my SE tax as an above-the-line deduction but better safe than sorry with the IRS.
Check out this post to read more about paying taxes when you’re self-employed!
What it really means to be an S Corp
With an S Corporation, the business is a separate entity and will have its own separate tax return (due on March 15th of every year, while personal income taxes are due April 15th).
As the owner of the S Corp you’re considered an employee and must pay yourself a reasonable salary along with distributions from any additional profits.
Since an S Corp is a totally separate business identity it will have its own tax bracket and will not be subject to SE tax. This is why electing to be an S Corp is tempting for a lot of small businesses.
Additional operating costs as an S Corp
As an S Corp you’re required to set up payroll for you and any other employees of the company. This means working with a payroll company like Gusto to divvy out monthly salaries and submit payments for payroll taxes.
Plus, any salary that the S Corp pays to an owner is also subject to state and federal unemployment tax (not to mention worker’s comp in certain states).
All of these additional taxes can really add up!
Not to mention the cost of paying a company to handle the payroll, and an accountant to file a separate tax return every year. And unless you become your own bookkeeper, you’ll have to pay for one of those as well.
See how this all adds up? Now, you’re probably starting to understand why I chose to be a single-member LLC, right? ?
An LLC is much more straight-forward and comes with easier bookkeeping versus an S Corp — it’s not just about calculating the tax savings because you have to think about the additional cost of doing business plus payroll taxes.
Let’s break this down with some real numbers.
For simplicity sake let’s say that my business makes $100,000 (net) every year. Here’s how it works out being taxed as an LLC versus an S Corp — including additional business costs and taxes.
LLC – $100,000 income
All of this income is considered personal income and is listed on my Schedule C which flows to the front of my personal tax return.
According to this corporation calculator, the taxes paid as a sole proprietor with a salary of $100,000 comes to a total of $14,581 (not including state tax of 4.63% for Colorado, or $4,630).
You can use the actual SE Form to calculate a more exact number.
- Total tax owed for LLC: $19,211 (includes SE tax)
- Bookkeeping software: $200
- Tax filing service: $79 (I DIY my self-employed tax filing every year)
- Payroll taxes: $0
- Annual cost for LLC: $10 (yearly in Colorado)
Total yearly expense and tax paid as a single-member LLC: $19,500
S Corp – $100,000 revenue
Let’s say that as the owner of the company I pay myself 50% of all the revenue my business earns, or in this case a $50,000 yearly salary. This would be considered a “reasonable salary” in my career field.
Using the same calculator, payroll taxes paid as an S Corp with the same revenue comes to $7,650.
Now, at first glance this looks like a HUGE amount of tax savings (and it is!) of nearly $7,000 compared to being an LLC. But let’s see how much you really save when you start adding in the costs of doing business as an S Corp.
- Total payroll taxes owed for S Corp: $7,650 (employer + employee portion)
- Bookkeeper: $1,380 (a service like Bench starts at $115 per month)
- Tax filing service or CPA: $806 (the average cost for preparing an 1120S)
- Payroll company: $540 (a service like Gusto starts at $39 per month + more for each employee)
- State and federal unemployment taxes: $230 (based on averages)
- Pass through taxes: $2,315 (in the state of CO owners of S Corps pay a 4.63% corporate state tax)
- Annual cost for S Corp: $50 (yearly fee in Colorado)
Total yearly expense and tax paid as an S Corp: $12,971
BUT, we’re still not done yet.
You still have to calculate the federal part of your personal income tax for both of these scenarios. I was only calculating the self-employment tax portion in order to keep it simplified.
Total yearly expense and tax paid as an S Corp and individual: $12,971 + federal income tax.
In case you haven’t already guessed, this strategy basically means your company’s profits will be taxed twice — once on the company side, and again once the income is passed on to the owners/shareholders.
As you can see, choosing to be an S Corp may save money on taxes, but after calculating my own personal income taxes (my husband’s income, and state tax), in the end I’d actually LOSE money as an individual and owner of the business.
This is why it’s SOOOOO important to take a look at how your tax situation affects you both personally and professionally.
Hacking the new tax bill
As of December 2017, the Republicans are pushing through a new tax bill that actually encourages small businesses to operate as a “pass through” business entity. (Just scroll down towards the middle of the article).
Here’s a quote:
“If you run a pass-through business that earns up to $157,500 a year if you’re single ($315,000 if you’re married), you get a 20 percent tax break on all profit that comes through your company — in other words, only 80 percent of that income would be taxed.”
This is giving an even larger incentive for solopreneurs and small business owners like us to become an LLC. And now you’re seeing why I decided to simply be a single-member LLC. ?
Still not sure what your small business entity should be? The great thing about the decision to become an LLC or S Corp is that you can take your time!
The current tax law allows you to switch tax-free to an S Corporation once you become an LLC. However, make your decision carefully because you can not do the reverse. Once you are an S Corporation, you can not switch back to an LLC.
Just a few things to keep in mind when choosing the best business entity.
I hope that my personal example and choice will help you make a decision that’s right for you!