Even when you’re the only one in your business, tax and legal matters are inevitable. And when it’s just you, you’re the one who has to handle them.
Knowing the best legal and tax structures for your business, the difference between S Corps and LLCs, and identifying the benefits of each is the best place to start. The information floating around can make it all seem extremely complicated and intimidating. But it doesn’t have to be.
A major decision you as an entrepreneur might face as your business grows is choosing between an S Corp versus an LLC. These actually aren’t opposing options. They work together to provide legal and tax benefits for your business. Forming an LLC without becoming an S Corp could mean missing out on serious tax savings.
Here’s everything you need to know about the differences between S Corps and LLCs – and how to know when each is right for your business.
The Difference between LLC and S Corp
As a Business-of-One, you’ve probably heard the terms “LLC” and “S Corp” a ton. You’ve probably heard them used incorrectly a ton, too.
There’s a lot of confusion among new business owners around business entities, so let’s get this important distinction straight about an S Corp versus LLC:
- An LLC or Limited Liability Company is a legal structure for a business that separates your personal and business assets and protects your personal assets from business liabilities.
- An S Corp or S Corporation is a tax election – not a legal structure – for a business that determines how it is taxed at the federal and state levels..
When you work as a solo operator or freelancer, you are the business. There’s no distinction. That means you pay personal taxes on everything you make through your business, and all of your personal assets are fair game if you’re sued or owe debts.
As your business grows, formalizing it as a legal structure could help you take advantage of the liability protection and tax benefits that come with separating yourself from your business. The legal structure is the first step to doing that.
LLC is the most common legal structure for a small business – other options include partnership or corporation. To set up an LLC, you first choose a business name and file paperwork with the state. That establishes your business as a separate legal entity. See our guide on How to Start an LLC for all 50 States.
A single-member LLC – an LLC with just one owner/employer, you – will be taxed like a sole proprietorship. That’s the same tax treatment you’d get if you hadn’t formally organized the business – and it has some drawbacks if you’re making about $80,000 or more per year.
To lighten your tax load, you can ask the IRS to tax your LLC as an S Corp, an election under subchapter S of the Internal Revenue Code, that adjusts how you pay taxes on different parts of your income – and usually lowers your tax bill.
S Corp vs. LLC taxes
The IRS assigns every business structure a default tax treatment – which determines how your business is taxed.
A single-member LLC is taxed as a sole proprietorship. That means you pay a 15.3% FICA tax –commonly referred to as self-employment tax – on all the taxable income you earn from your business. You also pay personal income tax at a rate determined by your tax bracket.
A single-member LLC taxed as an S Corp splits up that income and tax burden. As an S Corp owner, you pay yourself a salary, which has to be “reasonable compensation,” – similar to what you’d make as an employee performing the same job.
You personally pay half of the 15.3% in payroll taxes, a small FUTA tax, and personal income taxes on that salary. Your business pays the other 7.65% in payroll taxes which can then be written off as a tax deduction. The rest of the company profits you earn could be taken as “distributions” which aren’t subject to payroll taxes.
What are distributions you ask? Distributions are money that you take out of your business personally, by cutting yourself a check or transferring money to your personal account. Your distributions aren’t treated like self-employment income.
This single-member LLC vs S Corp business may sound a little complicated. Here’s an example to clear the air. Say you earn $120,000 in revenue this year, with $20,000 in business expenses. That’s $100,000 profit (congrats!). As a sole proprietor, you pay the self-employment tax plus your personal income tax on $100,000 minus personal deductions or adjustments.
As an S Corp, you could draw a salary of $50,000, and draw the remaining $50,000 as distributions. You pay payroll taxes on $50,000, plus personal income taxes on $100,000 minus personal deductions or adjustments.
Here’s how much you could save as an S Corp:
|Sole proprietor||S Corp|
|Profit (after payroll)||$100,000||$45,741|
|Self-employment tax(15.3% on 92.35% of income)||$14,130||$0|
|Employer payroll tax(7.65% + FUTA tax)||$0||$4,259|
|Employee payroll tax (7.65%)||$0||$3,825|
S Corp vs. LLC tax benefits calculator
Want to know how this could look for your business? Enter your information into our tax savings calculator to see how much you could possibly save by electing to have your business taxed as an S Corp.
Benefits of S Corp vs. LLC
Technically, LLC and S Corp aren’t opposing options. An S Corp (as opposed to a C corporation or LLC) is a tax status rather than a type of business. You have to form an LLC before you can elect to be taxed as an S Corp.
Here are a few things to consider if you’re deciding whether to elect S Corp status or simply form an LLC and pay taxes as a sole proprietorship.
Why would you choose an S Corporation?
If you’ve been working for yourself for a while, you’ve probably felt the burn of the self-employment tax. It’s a surprise to a lot of new business owners, and it’s why taxes feel like such a burden when you’re a Business-of-One versus an employee.
Electing S Corp taxation could help you cut the cost of self-employment tax significantly if your business income is a lot higher than a reasonable salary for your work. Plus S Corps are a pass-through tax structure and you’ll still be eligible for the Qualified Business Income (QBI) deduction, which can further lower your tax bill.
Technically, your taxation is split among the business and your personal payroll and income taxes, but in effect you’re still paying the self-employment tax – but only on the salary portion of your income, instead of all of the profits you earn from the business.
The disadvantages of an S Corp
The upside of an S Corp election is usually reduced corporate taxes. The drawback? Compared with continuing to work for yourself as a sole proprietor, it can be more complex. After organizing your business as an LLC, you must file the forms with the IRS.
Taxes also get more complex, because you have to pay yourself a regular paycheck and deduct payroll taxes throughout the year. You’re also required to pay quarterly estimated taxes for the business. At tax time, though, you still only have to file a personal income tax return.
Most, but not all, states recognize S Corp tax status. If you’re in a state that doesn’t, you’ll file taxes differently for federal and state, and that could get complicated.
You’ll probably want to enlist the help of a lawyer and accountant once your business is ready for this structure. Or sign up with Collective, and we’ll handle all the details for you.
The disadvantages of an LLC
Compared to an S Corp, the most relevant and potentially most expensive disadvantage of taxing your single-member LLC as a sole proprietorship is most likely a higher tax bill. If your business earns more in profit than the amount you’d pay yourself as reasonable compensation, electing S Corp status could save you money.
Which is better, an LLC or S Corp?
LLCs and S Corps provide different and sometimes complementary benefits to your company.
- Forming an LLC gives legal protection to your personal assets and doesn’t affect your taxes compared with operating as an individual or independent contractor.
- Electing S Corp taxation could reduce the amount of income you pay self-employment tax on.
If you form an LLC without electing S Corp taxation, you stand to pay more in taxes, because you’ll be taxed as a sole proprietorship by default. Electing S Corp taxation for your LLC could save you a lot of money in taxes each year.
Should your LLC be an S Corp?
If you’re now wondering, “should my LLC be an S Corp”, the key to that answer is the amount of profit your business earns. As a general guideline, if you earn about $80,000 or more in profit through your business, S Corp status is probably beneficial.
But that depends on how much you pay yourself as a salary. Figure out how much your reasonable compensation would be in your business first. If it’s less than your total profit, you could save money in federal taxes by electing S Corp status and drawing the difference as distributions instead of salary.
FAQs about LLC vs. S Corp
Business legal and tax terms are confusing. So let’s clear up a few common questions to help you determine whether to elect S Corp status for your LLC.
Who pays more taxes, an LLC or S Corp?
Typically, an LLC taxed as a sole proprietorship pays more taxes and S Corp tax status means paying less in taxes.
By default, an LLC pays taxes as a sole proprietorship, which includes self-employment tax on your total profits. An LLC can elect to instead be taxed as an S Corp, which reconfigures the income that’s subject to the self-employment tax – usually resulting in a lower tax bill.
If a reasonable salary for your job is less than your total business profits, you’d likely pay less in taxes as an S Corp. See our guide on “What Is an S Corp “Reasonable Salary“?.
Why an S Corp over an LLC?
If you form an LLC without electing S Corp taxation, you could have a higher tax bill. The IRS taxes an LLC as a sole proprietorship by default, which includes self-employment tax on all of your business’s profits.
Electing S Corp status for your LLC could reduce the amount of income subject to self-employment tax. Ultimately reducing what you pay in taxes overall.
What is a reasonable S Corp salary?
As an employee-owner of your business, you get to decide what to pay yourself. With S Corp taxation, paying yourself a salary less than your total business profits could mean serious tax savings. To keep you from taking advantage of that option and skipping out on fair taxes, the IRS requires you to pay yourself “reasonable compensation.”
It doesn’t clearly define what is “reasonable”. A general rule is that it has to be at least what other businesses pay for similar services. What would you earn if you were employed by another company to do what you do for your business?
You can adjust your compensation based on your business’s unique circumstances, including:
- Hours worked
- How much of the business’s profits are directly attributable to your efforts versus things like employees, property sales, and passive income.
Do S Corp owners have to take a salary?
Yes, in almost all cases, employee-owners have to take a salary in an amount that’s aligned with their work for the business.
How do I know if my LLC is an S Corp?
No LLC is automatically classified as an S Corp for tax purposes. The IRS will tax your LLC as a sole proprietorship by default. You have to file a form to request S Corp tax treatment.
What is the S Corp tax rate?
It varies. An S Corp does not have a separate income tax rate like a C Corp. Because it’s considered a pass-through entity, profits are passed through to the owner and taxed as personal income based on the owner’s tax bracket.
How to change LLC to S Corp
In order to receive S Corp tax status you must first form an LLC. The exact process of doing so depends from state to state, but involves selecting a business name, filing an articles of organization, selecting a registered agent, and creating an operating agreement. There will also be associated fees, such as the articles of incorporation fee.
After incorporation as an LLC and meet the requirements (such as having less than 100 shareholders) you can then file form 2553, “Election by a Small Business Corporation”. The process is fairly quick and should be completed in most cases within a few business days.
Once your business receives S Corp status, you can continue to enjoy the benefits of the owner of an LLC such as limited liability protection with the added tax benefits of an S corporation.
TL;DR: Should you convert from an LLC to an S Corp?
By the time you’re ready to form an LLC for your business, there’s a good chance you’re also a good fit for S Corp treatment on your taxes. This might not be the case if you work in a particularly risky profession, where you might form an LLC early for personal liability protection.
In most cases, if your business has reached a point where you’re ready to make it official, you likely earn enough that an S Corp election could help you save thousands of dollars each year in taxes.
Thanks to Collective, I don’t have to worry about bookkeeping, taxes and other government related tasks and can focus 100% on my work. If you’re self-employed and need help with tax, bookkeeping and ongoing support, all-in-one place, you’ll love Collective!
Arjun Dev Arora
Strategy, Venture, Technology
Andi Smiles, small business financial consultant and coach, teaches rad business owners to take control of their finances so they can step into their personal power.
She’s helped hundreds of self-employed folx organize and understand their business finances, while also uncovering their emotional relationship with money. Andi’s core belief is that when business owners are engaged with their finances, their personal awareness around money deepens, creating more sustainable and authentic businesses. She loves helping business owners connect with and feel good about their finances- no matter how many dollars are in their bank account.