Are you confused by the whole LLC vs. S-Corp thing?
The truth is, if you get this decision wrong it could cost your business tens of thousands of dollars - every single year!
But don’t worry, in this blog I’m going to break down everything you need to know about LLCs & S-Corps so you can think through which of these options is best for your business.
To kick things off, it’s important to understand exactly what LLCs and S-Corps are and what they are not.
LLCs are one of four basic types of Business Entities.
The other three are:
✅ Corporations,
✅ Partnerships and
✅ Sole-Proprietorships
If you’d like me to do another post where I break down the differences between these four types, let me know in the comment section below!
Now, did you notice that my list of Business Entities did not include the S-Corp?
That’s actually because the S-Corp isn’t a type of Business Entity.
Instead, it’s a tax election that you make with the IRS.
More specifically, the S-Corp determines how your business’ payroll taxes are calculated.
I want you to think of the S-Corp like an umbrella for your LLC.
Imagine this:
Your LLC is walking down the street minding its own business, having an amazing day then out of nowhere, it starts pouring!
But instead of pouring rain, it’s actually pouring Payroll Taxes.
So you pull out your trust S-Corp umbrella and you crack a grin as you watch a lot of these payroll taxes safely splash away from your LLC.
That S-Corp umbrella potentially just helped you avoid literally tens of thousands of dollars in unnecessary payroll taxes every single year.
Is the S-Corp for everyone:
Now, it probably sounds like this Gucci magic that is the S-Corp section is a no-brainer for EVERYONE — but not so fast, Kemosabe.
S-Corps come with some behind-the-scenes fees that could outweigh the benefits.
So, how are you supposed to know if you should S-Corp up or not?
Payroll Taxes 101:
We can answer that question by first explaining exactly how Payroll Taxes work.
Let’s assume that you work for The Man (AKA you have a job or work for someone else) and let’s assume that you make $40,000/year salary in that job.
You know that just because you get a $40,000/year salary that does not mean that you’re going to take home $40,000/year and that is because of taxes.
One of those taxes that comes out of your paycheck every single month is known as Payroll Taxes.
You might have seen these Payroll Taxes show up on your pay stub as FICA Taxes or Medicare or Social Security Taxes.
Every single payday, the IRS is going to force your employer to withhold 7.65% of your paycheck for Payroll Taxes.
That comes out to a little bit over $3,000/year in this example.
But what a lot of people don’t understand is that these FICA taxes aka Payroll Taxes, are not just 7.65% of your pay.
They are actually 15.3%!
Your employer pays the other 7.65% of your Payroll Taxes.
So you’re paying 7.65% of your salary to the IRS and your employer is paying 7.65%.
It is important for you to remember that because it is going to come into play here in just a minute.
How to think through the S-Corp decision:
Now that you have an understanding of how Payroll Taxes work, let’s use that information to determine whether or not your business should be an LLC or an LLC with the S-Corp Election.
The first thing you have to remember is that good ol’ Uncle Sam wants that sweet sweet PAYROLL TAX money, even if you’re a business owner with no employees.
But if payroll taxes come out of salaries AND if you have no employees, how does Uncle Sam get paid?
Well that all depends on if you’re an LLC or if you're an LLC with the S-Corp Election.
We know that, in general, the P&L tells us that:
REVENUE - EXPENSES = NET PROFIT
And as far as the IRS is concerned, the net profit that shows up on your P&L every year is your income from your business - EVEN IF YOU DIDN'T TAKE A PENNY OF THAT HOME!
Let's consider an example of a NON S-Corp:
Let’s say that your business did $250,000 in revenue last year...
And along with that revenue your business had $150,000 in expenses.
That means your business’ net profit was $100,000.
As I mentioned before, the IRS considers the net profit from your business as your personal income.
That means as far as taxes go, the IRS considers your personal income to be $100,000 even if you didn’t take a single dollar home with you.
Remember, the government wants 15.3% of your income for Payroll Taxes.
Using the above example, they are going to withhold 15.3% of your $100,000 income at the end of the year which comes out to in payroll taxes.
And you’re probably still gonna have to pay income, and maybe some other taxes, on top of that.
That absolutely sucks!
Now it's time for the S-Corp:
When you take the S-Corp Election you actually become an employee of your company.
As an employee you have to pay yourself what is known as a Reasonable Wage.
The good news is that this “reasonable wage” becomes an expense that will hit your P&L.
Let’s revisit the example from earlier but this time we’re going to have one big change:
Now you’re an S-Corp and your reasonable wage is $40,000.
Just like before, your revenue was $250,000
Your expenses were $150,000
But now you’ve got the additional expense of $40,000 from your reasonable wage which will bring your expenses from $150,000 to $190,000.
From here we calculate our net profit by taking our $250,000 in revenue and subtracting that $190,000 in expense, leaving us with $60,000 in net profit.
Here's How the S-Corp Helps:
Two big things happen now that you’re an S-Corp.
First, you’re gonna have to pay Payroll Taxes on the $40,000 you paid yourself in salary.
Now just like when you worked for "The Man", 7.65% of your salary is going to come out of your paycheck as the “employee” and the other is going to be paid by your “employer” (AKA your company).
Between those two, a grand total of $6,125 is going to be paid in Payroll Taxes.
But now that you’re an S-Corp you don’t have to pay the 15.3% in FICA taxes on the remaining net profit of $60,000.
That's a savings of $9,180/year.
And that is where all that Gucci S-Corp magic comes into play.
We should all want to be S-Corps right?
The Potential Downsides:
Well, like I said earlier, that is not always necessarily the case and that’s because S-Corps aren’t all rainbows, butterflies and 50%-off Happy Hour White Claws.
There are some downsides to becoming an S-Corp.
First, in order to become an S-Corp, you have to file some specialized paperwork with the IRS.
That paperwork can be fairly complicated so you’re probably going to want to have a CPA or Tax Professional fill out that paperwork and file it for you - which means you’re going to have to pay them to do it.
Second, because you’re an S-Corp, now you’re going to have to pay yourself a reasonable wage or salary.
How much is that reasonable wage?
Well it can depend on a lot of factors so you absolutely want to talk to your CPA or tax professional to get some more information on what you should be paying yourself.
The downside is, if you get this number wrong, you could end up either over or under paying in taxes.
Both of those are no good.
Third, you’ll probably going to want to get the help of a payroll provider like Quickbooks Payroll or Gusto to help you with the month-in, month-out calculations, filings, paperwork and all those kinds of things. And payroll providers DO cost money.
Finally, you’re going to have to pay your CPA to file some additional tax forms at the end of the year and there’s a cost that comes along with that as well.
TLDR: There are absolutely some administrative expenses that come along with being an S-Corp and if you file to become an S-Corp before you have enough net profit, those administrative expenses could outweigh the tax benefits that you might get as an S-corp.
How to determine:
So how should you determine whether or not you should be an S-Corp?
First, I strongly encourage you to work hand-in-hand with your tax preparer, CPA or tax professional and have them go through the math to determine what those expenses are and how they compare to the tax savings you’re going to get.
Have them show you the math so that you can make a decision with confidence about whether or not an S-Corp works for you.
Rule of thumb: I generally tell people, somewhere around the time
your business is hitting the $50,000-60,000 mark in net profit is generally
when you want to start having those conversations with your CPA.
Again, your mileage may vary so definitely work shoulder-to-shoulder
with your CPA to do the math and figure out what is right for you.
Don’t just guess!
