Should I be an S-Corp or an LLC? I get asked this question every day.
Correctly structuring your business is crucial to its success. You need to make sure you pick a tax-advantaged structure that leaves room for your business to grow. However, understanding the differences between an LLC and an S-Corp can be confusing.
By the end of this article, you will understand the differences between an LLC and an S-corp. Also, you will be able to decide if becoming an S-corp is right for your business.
What is an LLC?
An LLC, short for limited liability company, is a business structure that protects the owners from being personally liable against the company’s debts. This means that if the company gets sued or cannot pay its debts, the debt collectors cannot go after the owner’s personal assets. If your company is not organized as an LLC, the debt collectors would be able to seize your personal assets such as your house and your bank accounts.
LLCs are considered “pass-through” entities by the IRS which means they are taxed the same as a sole proprietorship. Therefore, as an LLC owner, you will have to pay taxes on your share of all of the income the LLC made, regardless of how much money you pay yourself.
What is an S-Corp?
An S-Corp, short for S-Corporation, is not a type of business structure like an LLC. Instead, it is a tax classification that LLCs and corporations may elect. S-corps are taxed largely the same as LLCs. However, S-Corps can treat owners as employees, which can have tax benefits that we will discuss later.
While almost anyone can create an LLC, there are some rules you must meet to qualify to elect S-Corp status:
- You must be a U.S. business.
- You cannot have more than 100 shareholders, aka owners.
- Shareholders can be individuals and certain trusts and estates.
- Shareholders cannot be corporations, partnerships, or non-resident aliens.
- You can only have one class of stock.
What is the difference between an LLC and an S-Corp?
The main difference is that S-Corps can treat its owners as employees. In an LLC, all income is subject to the 15.3% self-employment tax. With an S-Corp, you can pay yourself part of your income as a “reasonable salary”. Only this salary is subject to the 15.3% self-employment tax. No set number constitutes a “reasonable salary.” Still, the general rule is not to pay yourself a salary of less than 50% of your income.
Let’s run through an example to understand this tax benefit better:
Let’s say you own an LLC that made $100K in profit this year. Unfortunately, this means you will have to pay $15,300 in self-employment taxes.
Now let’s say you own an S-Corp that made $100K in profit this year, and you also paid yourself a salary of $60K. This leaves $60K subject to the self-employment tax, which means you will pay $9,180 in self-employment taxes.
So in this example, an S-Corp would save $6,120 in self-employment taxes for the year.
The structure of an S-Corp tends to be more rigid than that of an LLC. For example, LLCs are allowed to have an unlimited number of owners. S-Corps are capped at 100. Additionally, if you are not a citizen of the U.S., you are not allowed to be an owner of an S-Corp.
S-Corps are allowed to issue stock, but they can only issue one class of stock. LLCs are not allowed to issue stock. However, the various classes of equity an LLC can create may enable your business to have more flexibility.
Finally, LLCs are allowed to own an unlimited number of subsidiaries without restriction. However, an S-Corp is not permitted to own any.
What are the Benefits of an S-Corp?
- Personal liability protection
- Lower self-employment taxes than an LLC
Like an LLC, you will have personal liability protection if your company gets sued or becomes insolvent. However, an S-corp’s main advantage over an LLC is the tax benefit. You could save a significant amount of money each year because owners of S-corps can pay less self-employment taxes than owners of an LLC.
What are the Disadvantages of an S-Corp?
- Limited to 100 U.S. based owners and 1 class of stock
- More difficult tax accounting
There is a sweet spot for companies to elect S-corp status. Larger companies with more than 100 owners cannot elect S-corp status. For smaller companies that make less than $60K a year, it may not be worth it to elect S-corp status. It may not be worth it because an S-Corp’s tax benefit comes with a more complex tax return. A more complicated tax return means you might have to hire a CPA, which would negate your tax savings.
Should I make my LLC an S-Corp?
Like most things in life – it depends. Electing to be taxed as an S-corp is an excellent idea for most small businesses. It is an excellent idea because you get the same liability protection as an LLC with the added benefit of paying less self-employment taxes.
However, suppose you plan to have a large number of owners or attract foreign investors. In that case, you are better off remaining as an LLC or filing as a C-Corporation.
How do I convert my LLC into an S-Corp?
Electing to be taxed as an S-corp is a straightforward process. The only step is to file Form 2553 by March 15th of that tax year for the election to go into effect.
So if you want to elect S-corp status for 2022, you must file Form 2553 by March 15th, 2022.
Taxes can be one of the biggest expenses for a business. That’s why it’s so important to try to minimize your taxes. If your company makes more than $60K a year and meets the other requirements, you should seriously consider electing to tax your LLC as an S-corporation.
At Windstone Financial, we have helped numerous companies set up LLCs and elect S-corp status. If you need help structuring your company correctly, click the button below to get in touch.