Discover the difference between an S-Corp and an LLC, how to decide what route you want to take for your taxes, and how to save money when tax time comes.
Okay, so business and tax stuff isn’t the most exciting topic. But you know what is exciting? Saving money!
Think of your business as kind of like a… choose your own adventure story. You can choose the path that is right for you and that will save you the most money. Will you choose to be taxed as a pass-through entity like an S-Corp, or will you choose double taxation as a C-Corp? (Don’t worry, these are big, scary-sounding words for pretty straightforward things! Keep reading and allllll will become clear…)
Which path will you choose?
What’s the Difference between an S-Corp and an LLC?
S-Corps and LLCs actually belong to two different worlds. An S-Corp is a tax designation (that is, it’s how the IRS sees and taxes your business) and an LLC (limited liability company) is a business entity (a type of business).
You can choose to make your business an LLC and then be taxed like an S-Corp if you want (this is called S-Corp Election). Or you could become an LLC and just remain being taxed like a sole proprietorship (business owned by 1 person) or even like a C-Corp (more on that later!).
The main thing to remember: S-Corp = tax treatment, LLC = type of business.
What’s an LLC?
An LLC (limited liability company) is a type of formal structure for a business.
An LLC is a type of business entity that allows business owners to limit their liability in business dealings. In an LLC, a business owner is not personally liable if the business is sued. Basically, it means that if someone is suing the business, they can go after your business assets but not you personally (it gives you and your money some protection).
LLCs have flexible tax status and can elect to be taxed by the IRS in a variety of ways. By default, they are either taxed as a disregarded entity or sole proprietorship (1 owner) or as a partnership (2 or more owners). Owners can also elect to to have their LLC taxed as an S-Corp or C-Corp.
So… What Exactly Is an S-Corp?
An S-Corp (or an S-Corporation) is a business entity (LLC or corporation) that has elected (chosen) to be taxed in a certain way. A business entity that has elected to be taxed as an S-Corp doesn’t pay any tax itself, but instead passes its profits on to its shareholders (owners). Those shareholders, when doing their own income taxes, report that income and are taxed individually. This type of tax entity is called a pass-through entity (because the profits and the taxes are passed right on through to the shareholders).
Fun Fact! It’s called an S-Corp because the part of the IRS regulations that cover this stuff is called Subchapter S of Chapter 1 of the Internal Revenue Code.
Toby thinks that’s extremely fascinating.
What Is S-Corp Election?
S-Corp election is when a business entity notifies the IRS that it is choosing (or “electing”) to be taxed as an S-Corp.
How Do I Elect to Be Taxed as an S-Corp?
The first step before electing to be taxed as an S-Corp should be forming either an LLC or a corporation. Then, you can elect (choose) how you want to be taxed.
To elect to become an S-Corp, you have to tell the IRS that you want to be one. Your corporation or LLC has to submit a Form 2553 Election by a Small Business Corporation, which is signed by all your shareholders. You can find the form on the IRS website.
If you haven’t chosen or formed your business entity, you should start there first. Check out this post on choosing the right business entity for your business.
Requirements to Elect to Be Taxed an S-Corp
The IRS has just a few requirements if you want to be an S-Corp (they get a little technical, so it’s best to talk to a tax professional or a CPA about this… just keep these things in mind):
- Your business has to be a corporation, LLC, or other eligible business entity in the US
- Your business can’t have more than 100 shareholders (owners)
- Your shareholders must either be individual people, certain trusts, or estates. They can’t be partnerships, corporations, or non-resident alien shareholders
- Your business must only have one class of stock, and
- Your business can’t be an ineligible corporation (like some financial institutions, insurance companies, etc.).
Don’t worry—most LLCs, especially small businesses, qualify for S-Corp election.
When to Make the Decision to Become an S-Corp
It’s extremely important that you talk to your accountant or a CPA (Certified Public Accountant) about possibly electing to be taxed as an S-Corp.
Depending on your business’s unique situation, it may or may not be the best choice for you.
If you’re unsure whether it’s worth discussing with your accountant or a CPA, here are some advantages and disadvantages of S-Corp election:
There is one main advantage to electing to be taxed as an S-Corp, and that’s having to pay less in self-employment taxes.
Self-employment taxes include taxes for Social Security and Medicare and total 15.3% of your net income.
When you elect to be taxed as an S-Corp, it saves your business from “double taxation”, which is when income is taxed at the corporate level and then at the shareholder level (ew!).
An S-Corp owner can choose to receive both dividend and salary payments from the business, meaning they are taxed less since dividends are not subject to self-employment tax. This is sometimes called “income splitting”.
For example, let’s say you own a copywriting business that pulls in $100,000 per year. If you’re being taxed as an S-Corp, you can split that amount: $70,000 as salary and $30,000 as a distribution payment/dividend. That means you’ll only have to pay self-employment taxes on the $70,000 instead of the full 100k!
One important thing to note: the salary you pay yourself has to be reasonable given the work you do. You can’t game the system by paying yourself $30,000 in salary and $70,000 in distributions. That’s a great way to get audited and face penalties from the IRS!
- There are some strict requirements by the IRS to become an S-Corp (see the bullet list above!).
- If you’ve elected to be taxed as an S-Corp, that means you, as the business owner, will be “on the payroll”. That means you may have to deal with additional administration tasks that you otherwise wouldn’t if you hadn’t elected to be taxed as an S-Corp. This can become complicated very quickly.
- You have a higher chance of being audited by the IRS.
- You have to keep a closer eye on how much you’re contributing to Social Security—if you’re taking a lower salary, you may not be contributing as much as you should be.
- Your retirement (e.g., 401K) contributions might be lower since the contributions are based on how much salary you’re paid by your S-Corp.
Putting It Together
Whoa, we learned a lot today. High five.
Low fives are fun, too!
Let’s just recap for a hot minute:
- An S-Corp (S-Corporation) is a business entity that is taxed a certain way by the IRS. S-Corporations are pass-through entities that pass their income (and tax responsibilities!) right through to their shareholders instead of being taxed themselves.
- An LLC (limited liability company) is a more formal business structure than a partnership or a sole proprietorship and gives some protection to the business owner if the business is sued.
- An LLC can be flexible with their tax status and can choose to be taxed like an S-Corp, C-Corp, or just like a regular sole proprietorship or partnership.
- Making the S-Corp Election can save you money when it comes to taxes, depending on your business’s unique situation. Talk to your accountant or CPA to figure out if becoming an S-Corp is the right choice for you.
There Are More Ways to Protect Your Money!
When you run a business, you have lots of expenses to pay. There are 4 areas of your business that have the biggest impact on your revenue that you may not have even thought of!
Artful Contracts has a comprehensive How to Legally Protect Your Money Program that can help you keep control over your business revenue.
The Program includes guidance on:
- what to do if you get sued
- how to distribute your revenue between accounts
- how to fire a client
- how to prevent missed or late payments from clients
- intellectual property (copyright, who owns what between you and your clients)
and a lot more.
If you’re looking for more ways to protect yourself and your business, check out the 9-Step Checklist to Protect Your Business Legally!
For other ways to protect your money and business, watch the free masterclass: How to Legally Protect & Grow Your Online Business So You Can Keep More of the Money You Make