Is an LLC or S-Corp Right for Me?
When you first start your business, one of the major decisions you must make includes deciding what kind of company you want to run. The IRS and the court system treat various classes of companies differently. There’s a sole proprietorship, partnership, LLC, S-corporation and a corporation.
In this blog, we’re going to talk about the tax advantages of an LLC or an S-corporation (S-corp) for a small or medium-sized business. There are many variables to consider when deciding on an LLC or an S-corp, but income taxes should be a part of the conversation when you figure out your option.
Your business must have three criteria for you to take advantage of the income tax structure associated with an LLC or S-corp. You must own a pass-through entity as defined by the IRS. That means the income passes through to the owners as part of the profits and losses of the company. The IRS then taxes each owner individually. If you choose to go the corporate route, your company might face liability for corporate income taxes in addition to your personal income taxes, although the IRS handles these separately.
As part of this structure, you must set up payroll for your pass-through entity. You get a share of the payroll as part of your income. However, you may have to submit payroll taxes to the IRS. If you take your share of the payroll, you also pay FICA taxes through your paychecks.
Your business should make enough profit for this structure to make sense. If your company is busy enough for you to hire more help, then consider onboarding employees so you can focus on running the business as opposed to accomplishing more mundane tasks.
The following are two simplified examples of how and when an LLC versus an S-corp works for you. They illustrate the reason for these types of structures. Of course, your business is different and unique, so these examples are only for illustrative purposes.
In example one, you have self-employed earned income. Because you are the employee and employer, you pay both of the ordinary income tax rates that wage earners pay every week and then you pay FICA taxes on top of that. In example two, you make pass-through income from an S-corporation in the form of a distribution of profit. At that point, you are only subject to ordinary income tax rates.
Let’s look at some hard numbers for your LLC that makes $100,000 per year and you’re single with no children. For Scenario A, you file your return as a sole proprietor of an LLC. You tax bill is $30,580, and that figure breaks down to $16,450 in regular income taxes plus $14,130 paid towards FICA taxes.
For Scenario B, you file an income tax return with an LLC filing as an S-corporation. You take a salary of $50,000 and the remaining $50,000 is a distribution of corporate profit. Your total tax bill comes to $24,403, which comes from $17,338 regular income tax plus $7,065 in FICA taxes.
The tax savings comes from paying less FICA taxes to the tune of $6,177 in one year. The downside is that you pay less into Social Security. Later in life, that translates into less of a Social Security benefit for you when you reach retirement age. However, you might consider adding your tax savings into a retirement account with a higher yield than Social Security insurance. That’s where talking to a CPA comes in handy.
Talk to Your CPA
With all of this being said this is certainly a conversation that you should be having with your CPA or tax preparer to see if you qualify for this type of tax treatment or not. A CPA knows the law when it comes to state and federal income taxes as they pertain to individuals and corporations. You can choose how to set up your company before you make legal and tax filings, and a CPA understands the ins, outs, advantages and disadvantages of each type of business.
Some states allow you to create different types of LLCs that have you as the sole proprietor, as part of a partnership or an S-corp. A CPA can go over your current financial situation to figure out what type of corporation is best for your needs. He or she will talk to you about your business goals, how much profit you plan to make and how quickly your small business should expand.
The flexibility with how you’re taxed gives you advantages in terms of how to spend or save money, but it may limit your income potential if you have one company versus another. More issues arise from legalities of different corporations and how you may defend your company should liabilities arise.
Talk to us at HD Davis CPAs to see what we can do for you. We can help achieve your dreams of owning your own business from when you start until you decide to retire.