LLC or S-Corp? A Clear Guide for Business Owners
Since 2020, America’s been experiencing a “small business boom,” with average monthly new business applications hitting 441,453—a 91% increase over pre-pandemic levels.1
If you, or you and your spouse, are business owners, you’re certainly in good company. But as you know, business ownership blazes a unique trail, especially if you’re accustomed to traditional salaried employment. One of the first decisions you’ll need to navigate on this journey is your business’s legal structure and tax status. While an LLC is the common choice for small businesses and solopreneurs, it’s not the only option available to you. An S-Corporation can, under the right circumstances, help you achieve significant tax savings—though there are important recordkeeping and compliance requirements to keep in mind.
Let’s take a closer look at each option, as choosing the right structure for your business can significantly impact both your bottom line and long-term wealth-building potential.
What Is an LLC?
An LLC is a legal business structure that offers owners liability protection. If you operate under an LLC, your personal assets are generally protected in the event your business is sued. Debt collectors can’t come after your personal home or assets to pay back business-related debt. An LLC is relatively simple to establish and maintain, and its legal protections can be significant. For this reason, it’s often the go-to option for solopreneurs, freelancers or contractors, and small business owners.
With an LLC, there’s no legal requirement to keep diligent meeting minute records—or even hold shareholder meetings, for that matter—like there would be with a traditional corporation (more on this in a minute). There are also no payroll requirements. Technically, your business doesn’t even require a separate bank account (though establishing one can certainly help with personal recordkeeping and is recommended).There are two primary types of LLCs:
Single-member LLCs are owned by one person and taxed as sole proprietorships.Multi-member LLCs are owned by two or more people and are typically taxed as partnerships.
LLC and Taxes
In both cases, the business doesn’t pay taxes directly. Instead, profits “pass through” to the owners’ personal tax return, and you pay self-employment tax on the business’s income.
Here’s the catch: Sole proprietors are responsible for paying both the employer and the employee side of FICA (Social Security and Medicare) taxes. As a normal W-2 worker, you would pay half the FICA tax (7.65%), and your employer would pay the other half. But because you’re self-employed, you’re responsible for paying the full 15.3%.But, as long as you keep adequate records and follow IRS guidelines, you can still deduct certain business expenses from an LLC using a profit and loss statement.
What Is an S-Corporation (or S-Corp)?
Unlike an LLC, an S-Corp isn’t a business entity type. Rather, it’s a tax status that a business can elect with the IRS.
An S-Corp is a legal business that has chosen to be taxed under Subchapter S of the Internal Revenue Code. The LLC legal structure is retained. Filing as an S-Corp requires payroll and stricter recordkeeping than a standard proprietorship or default LLC.More specifically, an S-Corp must meet the following criteria:2
- No more than 100 shareholders
- It must be a domestic corporation (U.S.-based)
- Employees, including the business owner, must receive a salary
S-Corp and Taxes
The appeal of an S-Corp is tax savings, specifically around those pesky self-employment taxes.
In an S-Corp, you’re considered both the business owner and an employee. As an employee, you pay 7.65% in FICA taxes (Social Security and Medicare) through payroll withholding. The business also pays an additional 7.65% on your behalf. However, the business’s share of the FICA taxes is tax-deductible, which helps reduce the overall tax burden. This setup effectively cuts the self-employment tax in half compared to a default LLC or sole proprietorship.Each tax season, an S-Corp must issue a Schedule K-1 to each shareholder, reporting their share of the company’s income, deductions, and credits. It is a pass-through entity, meaning shareholders report this information on their personal tax return and pay any tax liability individually.
Understanding S-Corp Salary Requirements & Benefits
An S-Corp allows you to split income into salary and profit distributions (also called shareholder distributions).
This is an important distinction since FICA tax only applies to an employee’s salary, not distributions. For this reason, the IRS requires S-Corp shareholders to take a “reasonable salary.” In other words, you can’t take a salary of $0 (or something unrealistically low) to avoid paying FICA taxes.In addition, you can offer yourself and other employees certain benefits, like health insurance, through the S-corp. The premiums paid through the company are tax-deductible.
Can You Have Both an LLC and an S-Corp?
Yes, your business can be both an LLC and an S-Corp. The LLC determines the legal structure, while the S-corp impacts the tax status and imposes certain requirements (like payroll).
When to Consider an S-Corp Election
It costs money (and time) to keep your S-Corp compliant. You may need to hire a bookkeeper or work with a business advisor in order to ensure you’re following all legal requirements. For this reason, the tax savings and other benefits need to outweigh the cost of maintaining the S-Corp. As a general rule of thumb, an S-Corp may be beneficial for those with an annual net income consistently over $75,000 or $100,000.
An S-Corp is also a helpful tool for building long-term wealth, particularly in retirement accounts. With a 401(k) for example, you can make both employer and employee contributions to the account.Which Is Right for You?
Here’s the bottom line: LLCs are flexible, easy to manage, and include fewer legal formalities. For businesses that are just getting off the ground, an LLC may be the more fitting option. But if you find your business profits growing substantially and you’re looking for opportunities to reduce the tax burden, it may be time to consider filing as an S-Corp.
Working with a financial advisor and CPA who understands both your business and your bigger-picture financial goals can help ensure your business structure supports not just your current needs, but your future legacy.
If you're still weighing your options or want a quick refresher, download our guide: LLC or S-Corp? A Clear Guide for Business Owners. It’s a great resource to help clarify what structure might serve you best.And when you're ready to talk it through, we invite you to schedule a Get-Acquainted meeting with our team.
Sources:
2 https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
Written by Julie Fortin in collaboration with Lexicon Advisor Marketing
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