LLC or S-Corp?

A few months ago I shared a bunch of info on self-employment tax. Here’s a quick recap:

Self-employment tax is the equivalent of FICA, but for freelancers, sole proprietors, partners in partnerships, and members of LLCs. All of those types of people have to pay self-employment tax. And that tax, like FICA, is used to pay into Social Security and Medicare.

One point I really leaned into in that previous post was that self-employment tax is owed on your total net business profits, regardless of whether you treat that money as compensation or not. That’s true even if those profits live in a dedicated business bank account and never hit your personal account. It’s ALL considered earned income. As a result, there is no way for those types of business owners to actually pay themselves a salary.

But there is an exception to the self-employment tax rules for small businesses, which is called the S-Corp election. I’ll admit, this is kind of a niche topic. But it’s important for anyone who runs a business and wants to know if they’re making the right decisions. I find that lots of people want to up their game, want to make their businesses more legit, but are totally confused about the differences among business structure options and what that choice means for both income and taxes.

Today we’re going to focus on the differences between LLCs and S-Corps. But let’s start with a quick overview of sole proprietors and partnerships before diving into LLCs.

A sole proprietor is pretty much anyone who trades work for money, but doesn’t have any formal business structure. So that certainly includes freelancers, but it also includes lots of musicians, artists, writers, certainly lots of roadies, which is how I made my living for many years, and even a kid in your neighborhood who rakes leaves for cash. There is absolutely no difference between the owner and the business when it comes to income, profits, or liability for sole proprietors. Business income is your income, business liabilities are your liabilities.

Partnerships are basically like sole proprietors, but they have more people. Partners share in both profits and losses, and there is no liability protection between the business and the owners (or among different owners).

A Limited Liability Company, or LLC, is organized and registered at the state level. It’s pretty easy to do and typically costs a few hundred bucks a year to maintain. And what it does, as the name implies, is limit the liability between the company and the company owner. So for example, if someone walks into your office and slips on a banana peel, they can sue the business, but your personal assets can be excluded from that lawsuit. It might mean the end of your business; but you’ll get to keep your house and your car, and all your stuff. LLCs also protect members, which is what LLC owners are called, from liability for other members. One example is if a member in a multi-member LLC gets divorced. That person’s slice of the business will get looped into the divorce process, but the other members’ ownership or personal assets are not at stake.

Honestly, there are very few downsides to registering an LLC if you work for yourself. It doesn’t cost all that much and, if there’s ANY possibility at all that you might get sued for any part of your work, you’ll be glad that there’s some separation between business and personal. You don’t have to have an LLC if you work for yourself, of course, and there are situations where the odds of somebody suing you are so low that it doesn’t matter. I’ll admit, I have a little trouble imagining a litigation-proof business, but those situations exist. Or for certain other vocations where you’re required to have a lot of industry-specific professional insurance just to operate, you might already have plenty of liability protection. But for everyone else who is self-employed, I think it’s a great move for limiting your personal risk exposure without a lot of hassle.

But what an LLC does not do is change your tax status. Even though they offer lots of protection when it comes to legal and financial liability, LLCs offer no benefit when it comes to taxation. In fact, the IRS term for one-member LLCs is “disregarded entity”. Kind of a harsh toke for all the one-person LLCs, right? But when it comes to taxes, the IRS does not care whether you register your business as an LLC.

And that brings us to Subchapter S Corporations, also called S-Corps. While an LLC is a business organization but not a tax status, an S-Corp is a tax status but not a business organization. In other words, you must have already formed & registered your business before electing to be treated as an S-Corp. And an LLC can choose to be treated as an S-Corp for tax purposes by filling out and submitting IRS Form 2553. There are some rules that go along with that, they’re not super complicated, but I’m not going to get into that here.

So why would anyone want their business to be treated as an S-Corp? The main reason is that it allows you to treat yourself as an employee and pay yourself a salary. In other words, you can carve out a portion of your net profits and treat that as earned income, on which FICA is due, and the rest of the profits can flow-through as ordinary income. Now, ordinary income is still subject to income tax. Ok? You’re not avoiding that with the S-corp election. But it avoids that extra 15ish% that you’d have to pay on top of income tax in the form of employment tax.

Here’s the thing: the IRS stipulates that – with very few exceptions – an S-corp owner, called a shareholder, must receive “reasonable compensation”. But the IRS doesn’t stipulate exactly what “reasonable” looks like. What’s reasonable compensation for being a musician? Or writing a book? Or making things that you sell on Etsy? It’s open to interpretation.

Now, I have my own ideas about how much of your net profits should be considered reasonable compensation. But I’m a CFP and not a CPA. A CPA is an expert in tax law and is authorized to represent you in tax court if you get audited. A CFP can’t do that, nor is there such a thing as advisor-client confidentiality for CFPs. So if you’re considering using the S-corp election, you should 100% get your CPA to sign off on the process and help decide what qualifies as “reasonable” for you & your business before you get started.

That said, here’s a quick back-of-the-napkin example. The calculation for self-employment tax is kind of complicated but works out to 14.13% of net profit, while FICA works out to 15.3% of earned income. Ok, so let’s say that you have a one-person business that generates $100k in net profits. If you are a sole proprietor, free lancer, or one-member LLC, that entire $100k is subject to self-employment tax and you’ll owe about $14,130 in self-employment taxes. Now let’s say that instead you have a one-member LLC and elect to be treated as an S-corp. Let’s also say that you and your CPA decide that $50,000 is a reasonable salary based on that $100k net profit. You will owe about $7,650 in FICA based on that salary, with the remaining profits flowing through as ordinary income and avoiding FICA. Remember: it’s still subject to income tax, but it avoids employment tax.

So in the scenarios described above, you would save in the ballpark of $6,500 in employment taxes by choosing the S-Corp election. Not bad, right? So why doesn’t everyone do this?

Well, the easy answer is that the S-Corp election is a lot more complicated. When you have a one-member LLC, you don’t have to worry about running payroll – because you can’t actually treat yourself as an employee – so you avoid all kinds of paperwork. That’s not true when your business is treated as an S-Corp. You have to regularly run payroll, which means making payments to the IRS and your state for income tax AND paying into FICA. You can’t just wait until the end of the year and see how it shakes out. You have to do a lot more paperwork and be more proactive about accounting and paying taxes in real time.

Another drawback of being treated as an S-Corp is that you can no longer claim a bunch of business expenses on your personal tax return like you can if you’re a freelancer, sole proprietor, partner in a partnership, or member of an LLC. That’s not a huge deal because you can either have the business pay those expenses directly or, since you can now treat yourself as an employee, you can submit receipts to your business and get reimbursed, the same way any employee would. The point is, though, that you’ll need to think about bookkeeping differently and be more on top of things as they happen instead of waiting until next year when it’s time to file taxes to add up all of those write-offs.

And finally, one downside of treating only a portion of your business profits as compensation means that you are paying less into Social Security and Medicare, which means that you will have lower benefits from those programs in retirement. That said, a great way to offset that risk is to take the money you save on taxes now and invest it for the future. Again, it’s not super hard, but it is one more thing you have to think about with an S-Corp.

So how do you know if the S-corp election is a good idea?

The most basic answer is pretty much “when you’re making more money than you need”. So if your business generates just enough profits for you to get by (or even less than that), then it probably isn’t worth the extra effort and filing requirements to be treated as an S-corp. If I had to put a ballpark number on it, I’d say you can start having that conversation when your net business profits approach $100k. Below that, it just might be too much work relative to the benefits.

Another reason you might want to choose the s-corp election is to avoid surprises at tax filing time. This is honestly why I chose to do it that way for my business. When I was still a roadie, I made more or less the same amount for several years in a row, but – depending on how the bands I worked for treated compensation – I might get a big refund or owe a bunch of money. I hated that uncertainty, so I chose the s-corp election when I launched Iseler Financial even though at that time there was no profit at all.

Ok, that’s probably enough on LLCs and S-Corps for now. I know that it’s kind of complicated, but I also know that SO MANY of the people I talk to and work with WANT to understand this better and don’t really know where to start. So hopefully you at least understand the basics when it comes to LLCs and S-corps and know what kinds of conversations you should be having next.

If you have a question about business structure, feel free to drop me a line. Or you can sign up for weekly office hours to ask your question with zero pressure.

Thanks,

Timothy Iseler, CFP®

Founder & Lead Advisor

Iseler Financial, LLC | Durham NC | (919) 666-7604

Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.