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When you’re starting a new business or taking steps to register with your state, you have a big decision to make: should you start an LLC or an S Corp? Both LLCs and S Corps provide significant legal and financial benefits. Depending on your income, however, the right choice could easily save you thousands of dollars per year on taxes. Follow along to learn more about the differences between LLCs and S Corps and which could be the best option for your business.
Taxes with an LLC or S Corp
When you earn money without a registered business, you are working as a sole proprietor by default. This may be okay for small hobby businesses that bring in a few thousand dollars per year, but serious business owners should look at the potential annual savings and legal protections of LLC and S Corp registration.
But first, what’s an S Corp? An S Corp is a tax designation. When you work with Collective, we form an LLC for you with default IRS tax treatment, which is to be taxed like a sole proprietor. Next, we file a form to elect for S Corp taxation even though you technically have an LLC. In this article, whenever we refer to an S Corp, we’re talking about an LLC with the S Corp tax election.
Your taxes work differently depending on the option you choose. Here are the most important parts to understand:
Taxes with an LLC
When you have an LLC, your business taxes are a part of your personal tax return. The IRS requires both sole proprietors and LLC owners to report revenue, expenses and profits using Schedule C, an addition to your annual 1040 tax filing.
One of the biggest benefits of going this route is the ease of filing taxes. Using accounting software or spreadsheets, you can tally up your business financials and use them when doing your personal taxes.
When filing taxes as an LLC, you pay regular income taxes on the profits your business earns. In addition, you pay self-employment tax, which includes the employer’s and employee’s contribution to Social Security and Medicare taxes. For 2020 taxes, this adds up to 15.3% of 92.35% of your business profits. If you earned $100,000, that’s nearly $15,000 in self-employment tax alone, not including your regular income taxes.
LLC registration may be a bit cheaper than S Corp registration. It also typically requires slightly less annual paperwork. But S Corp owners may be able to save more than enough on self-employment taxes to make up the difference.
Taxes with an S Corp
If you’re not familiar with S Corporations (we like to call them S Corps), setting one up is slightly different from an LLC and requires some additional annual paperwork to save money. For the business owner above who makes $100,000 per year, those savings are likely over $5,000. If you ask me, that’s worth a little more paperwork.
When you file taxes as an S Corp, your earnings are split up between regular payroll and business profits. You only have to pay the equivalent of self-employment tax on your paychecks. Any additional profits are only taxed at your regular income tax rate.
If you make $100,000 per year in total profits and pay yourself a salary of $60,000 per year, you would only pay self-employment tax on $60,000 per year, not the full $100,000. That means you would pay $9,180 in self-employment tax instead of nearly $15,000. To save you doing the mental math, that’s about $6,000 in annual tax savings.
Which is better: LLC or S Corp?
According to our calculations, the benefits for S Corp owners start at around $80,000 per year. If you make less than $80,000 per year in business profits and project that you’ll continue to do so, an LLC could make the most sense. If you project you’ll make $80,000 per year or more, you should seriously consider an S Corp.
As your income increases, the benefits of switching to an S Corp increase. It’s easier to set up a business one time than switch later on, so businesses who have a reasonable likelihood of making more than $80,000 per year on average may want to start with an S Corp even if they are not quite at the $80,000 mark just yet.
Are you a freelancer? Here’s your ultimate guide to getting freelance taxes done right.
Don’t forget the legal benefits
With a sole proprietorship, you are personally liable for anything that goes wrong with your business. If your product or service ever injures a customer, for example, they could sue for your personal assets. Business owners concerned about legal issues should consider consulting with a trusted legal professional about how your business can protect you from personal liability.
Freelancers, consultants, contractors and other service business owners may be open to financial liabilities for errors, omissions, mistakes, and other situations. Those who sell physical products may be exposed to injury lawsuits. You may want to consider business insurance for additional protection.
Why I use an S Corp for my freelance business
This math isn’t just made up stuff for tax wizards and millionaires with fancy accountants. I use an S Corp for my solo freelance business based out of my home in sunny Ventura, California. I started freelancing as a side hustle over a decade ago and used an LLC at the time, but when I decided to jump to full-time, I also registered as an S Corp.
Running a business in California isn’t cheap. I have to pay state taxes and federal taxes, but I pay a lot less, thanks to my registered business. Over the last four years, I estimate that I’ve saved well over $20,000 in self-employment taxes. While I love my country as much as the next guy, I’d much rather have that money in my bank account than hand it over to the IRS.
What about future Social Security benefits?
Using an S Corp to lower your self-employment tax also lowers your income in the eyes of Social Security. That means you will get a smaller Social Security benefit if you use an S Corp and save taxes now. However, the tax savings generally add up to more than the lost Social Security benefits and you can put your tax savings back into your retirement account.
Thanks to Collective, I don’t have to worry about bookkeeping, taxes and other government related tasks and can focus a 100% on my work. If you’re self-employed and need help with legal, tax, bookkeeping and ongoing support, all-in-one place, you’ll love Collective!
Arjun Dev Arora
Strategy, Venture, TechnologyGet started with Collective →
Optimize your growing business to work for you
One of the benefits of self-employment over working for someone else is keeping all of the profits for yourself. When you join Collective, you get access to a team of accountants, tax professionals, and legal experts who will register your S Corp, create a business bank account, do your taxes, offer bookkeeping support and more. QuickBooks (bookkeeping software) and Gusto (payroll) are both included at no extra charge.
Savvy business owners with growing businesses on track to earn $80,000 or more should consider an S Corp to save money on taxes while taking advantage of the legal protections of a registered business.
Starting an S Corp may seem overwhelming, but you do have a partner on standby waiting to help you with that part of your business. Check out Collective’s S Corp tax savings calculator to get an idea of how much you can save. If the numbers make sense for you, you can schedule an appointment with an advisor who can help get you on track to big savings. It’s never too late to start saving money.
Eric Rosenberg is a finance, travel, and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full-time. You can connect with him at Personal Profitability or EricRosenberg.com.