We see this scenario almost weekly. A valued client refers a business owner friend to our firm and the first thing they ask is: “I’m an LLC, but my friend said I should file as an S-corp. What should I do to save money on taxes?”
You know that how you structure your business will directly affect how much you pay in taxes, but when do you need to switch your structure to actually make an impact in what you pay?
Of course, there is no single solution that works for everyone. Legal, management, and tax considerations make the decision situational because everyone is different, including their business goals, tax situations, and their need for liability protection.
But, many business owners go through a progression of business structures based on their business stage and evolving financial circumstances.
So how does one go about choosing the proper business structure at any given time?
The first step is understanding their key differences and how they impact your financial and business goals. Assuming most businesses start as sole proprietorships with a single employee, limited income, and no apparent liability risks, the issue for many business owners eventually comes down to whether they should switch to an LLC (limited liability company) or an S-corporation or remain as a sole proprietor.
Sole Proprietorship is a Starting Point
The default entity for many people who start a business is a sole proprietorship, which is not so much a business structure as a tax election. Operating as a sole proprietorship tells the IRS that all your business income (less business deductions) passes directly to you and is taxed as personal income. There are no requirements for starting a sole proprietorship other than making estimated tax payments, filing an individual tax return, and paying FICA taxes.
However, there are no liability protections either. Essentially the individual is the business for the purposes of assigning blame for any liabilities, putting their personal assets at risk. For many types of businesses, business owners can protect themselves to a great extent with a personal umbrella liability insurance policy.
An LLC is for Legal Protections
Another way to minimize liability exposure is to structure the business as an LLC. An LLC is a legal status governed by individual states which formally differentiates the individual’s finances from the business. That way, any claims arising against the business cannot be filed against the individual.
However, an LLC is not a tax election. As with a sole proprietorship, business income flows directly to the individuals, or individuals if there are multiple owners, and is reported on their individual tax returns. If liability protection is the only concern, an LLC structure could suffice until the business is locked firmly on a growth trajectory. As the business grows, generating more income, hiring more employees, and requiring more business capital, business owners could benefit more from the S-corp structure.
S-Corp for Legal Protections and Tax Advantages
An S-corp is a subset of incorporated business structures that includes the C-corp. However, like a sole proprietorship, an S-corp is a tax election, not a legal status, though it does enjoy the same liability protections as an LLC. Business owners operating under the legal structure of an LLC can also elect to be taxed as an S-corp.
In an S-corp structure, the business owners are shareholders sharing in the profits of the business. Owners are also employees requiring that the business pay them a reasonable salary, which is a deductible expense for the business. That means that all profits are taxed at the shareholder level. Shareholders report their salaries on individual returns, and the S-corp reports its net profits or losses on a corporate return.
When is the Right Time to Switch from an LLC to an S-corp?
Small business owners tend to gravitate toward the LLC structure initially because it’s straightforward and offers more freedom and flexibility than an S-corp, which is subject to more rigid requirements regarding management structure and reporting. Under an S-corp structure, business owners must adhere to corporate bylaws and are often overseen by a board of directors.
That corporate structure has advantages over an LLC because the business can sell shares of stock to raise capital for growth, though the S-corp is limited to 100 shareholders. To that end, the corporate structure of an S-corp also projects more credibility than an LLC when trying to attract investors.
How an S-Corp Can Save Taxes
For many business owners, taxation is the critical determinant for switching to an S-corp. S-corp owners can pay lower taxes than LLC owners in two ways:
Self-employment taxes: LLC owners must pay self-employment taxes consisting of a 12.4% Social Security tax and a 2.9% Medicare tax directly to the IRS. S-corp shareholders are paid a salary. Hence, the business covers their payroll taxes, which the business can deduct.
Lower taxable income: All business income in an LLC is passed directly to the owners and taxed at their ordinary income tax rate. Owners of an S-corp receive a “reasonable” salary based on IRS guidelines, taxed as ordinary income. But, if the business has leftover profits, they can be distributed to shareholders as dividends, which are taxed at a more favorable rate.
So, as your business generates more revenue and your income increases, an S-corp may make more sense financially. Business and tax experts point to $60,000 of income as the threshold for making that decision. With the possibility of realizing tax savings, that’s the point when it might make sense to pay the higher costs of filing a corporate tax return.
Ultimately the decision must come down to your individual and business circumstances. Because of the significant legal and tax implications, it’s recommended that you asses your situation with your CPA and financial advisor.