S Corp vs LLC

90% of self-employed are in the wrong tax structure. The consequence? Most self-employed are overpaying their taxes by the thousands. So, the tax strategy experts at Formations are here to help you understand the differences of an LLC VS S Corp.

What is an S Corp?

An S Corporation (S Corp) is a filing election with the IRS. They run similarly to an LLC (a pass-through entity) but with the added benefits of a corporation.

You’ve likely heard the term pass-through entity; it simply means your business is not responsible for corporate taxes because the profits and losses pass to the owner(s), who becomes responsible for the taxes owed.

If you are considering the structure of your business, you might consider the S Corporation. An S Corp typically offers self-employed a better deal than LLCs, partnerships, or sole proprietorships.

At a Glance

S Corps offer significant tax benefits and lessen your self-employment taxes owed at the end of the year. You’ll have better access to benefits, protection against your assets, and credibility in your industry. But all those fantastic benefits come at a cost. The incorporation and complex compliance rules require both time and money for setup and ongoing maintenance of the business to comply. You’ll also need excellent bookkeeping practices and a way to issue payroll for yourself.

How It Works

While S Corporations don’t pay federal corporate taxes, they are liable for some corporate-level taxes on specific built-gains and passive income. But aside from their tax status, S Corps are similar to C Corporations (C Corps) or other corporations in that they are for-profit entities incorporated under (and governed by) the same state corporation laws. They offer similar liability protection, ownership, and management advantages as their C Corp counterparts.

However, S Corps are different because the IRS permits businesses to pass taxable income, credits, deductions, and losses directly to their owners. It’s important to note that this structure is only available to small businesses with 100 or fewer owners, making it a fantastic solution for many self-employed people.

How the S Corporation Stacks Up

What’s the Difference Between an S Corp vs LLC?

LLCs are a go-to structure for small businesses. Both are pass-through entities that offer limited liability protection for their owners, protecting personal assets from business creditors and preventing personal assets from being targeted in lawsuits filed against the company.

LLCs are more flexible than S Corps as they aren’t subject to specific IRS regulations concerning the number and type of shareholders (owners) or other federal and state rules regarding governance, procedure, and distribution of funds.

LLCs are more straightforward to establish than S Corporations, but without a specific tax election, they are still subject to the full self-employment tax liability.

What’s the Difference Between a C Corp vs S Corp?

The main difference between an S Corp and C Corp is how they are taxed. Profits from a C-Corp are taxed to the corporation, then taxed to the shareholders when distributed as dividends, creating a double tax. An S Corp may pass income directly to shareholders without paying federal corporate taxes.

View a more in-depth comparison here.

The Pros and Cons of S Corps

The Advantages of an S Corp

Tax Savings: not having to pay federal taxes at the entity level and saving money on corporate taxes is incredibly beneficial, especially when you reap the rewards of a corporate structure.
The S Corporation structure significantly reduces self-employment tax liability. S Corp status can lower the personal income tax for business owners because a self-employed individual becomes both the owner and employee of their own business. By becoming an employee of their own company, they receive a regular paycheck like their W2 peers. They also receive the business's profits, creating steady, predictable pay while reducing their self-employment tax liability.
S Corp stakeholders (owners) can be company employees who earn a salary and receive tax-free corporate dividends (so long as distribution does not exceed their stock basis).
Other advantages include transferring interest or adjusting property basis without facing adverse tax consequences or having to comply with complex accounting rules.
S Corp status establishes credibility amongst clients, peers, suppliers, partners, and more by showing the owner’s official commitment to the company.
By becoming an S Corp, self-employed individuals can access corporate-level benefits such as more options for healthcare and retirement savings.

Disadvantages of an S Corp

Because payroll taxes are avoided, the IRS pays close attention to how S Corps pay their employees. Employees must receive reasonable compensation before any distributions are made on profits.
Distributions are strictly based on the percentage of ownership or number of shares that each individual holds.
Setting up an S Corp can take time and money. The corporation must have a registered agent for the business and pay fees associated with incorporating (done with the Secretary of State where the company is based).

That’s a lot of Info. What Are the Highlights?

The easiest way to think of running an S Corporation as a self-employed professional is to imagine yourself wearing two hats: an employee hat and a CEO hat.

The Employee

You will receive a salary as if you were W2.
You should have a business expense reimbursement policy to be repaid by the business (and maximize business expenses).
If you primarily work from home, you can take advantage of the Business Use of Home deductions.
You may deduct business miles driven at the yearly IRS mileage rate and reimburse yourself as an employee for those incurred costs.

The CEO

As the stakeholder (owner) of the S Corp, you can withdraw funds directly from your business account as equity distributions (which is non-taxable in most cases).
Your personal assets will be protected should there be a lawsuit against your company.
You can set up retirement plans for yourself and your employees (that's right, you can double your savings).

S Corp Requirements

Tax Filing Requirements for S Corps

Although exempt from corporate taxes, S Corps must file business tax returns and report their earnings to the government. Form 1120-S (reports on income, losses, dividends, and other distributions) is used for S Corp tax filings and is frequently accompanied by a Schedule K-1.

They file their taxes annually like individual taxpayers (unlike C Corps, which file quarterly). Form 1120-S is due by March 15 (though you can request an extension with Form 7004).

Business Banking for S Corps

One of the compliance requirements to be an S Corporation is that you treat your business and personal finances as separate entities, so you’ll need to open a business bank account. Commingling finances can lead to severe consequences and increases your risk of an audit from state or federal authorities.

We also highly recommend a business credit card. Most banks will issue a card to a new business if given the majority owner's personal guarantee (you).

The perks? You’ll manage cash flow better and build credit for the company and yourself.

Running Payroll

As an S Corp, the IRS will want to see that you're paying yourself wages via payroll (reasonable compensation).
You can have the net check deposited directly into your personal bank account or write a check manually.
All necessary payroll filings (state or federal) are due quarterly and yearly.

What’s Reasonable Compensation?

Part of the requirements to run an S Corp include paying yourself a reasonable salary based on reasonable industry average wages. These generally run about 25-50% of your net income. For example, if the industry standard wage for your industry is 40% and you have a net income of $100,000, your reasonable compensation (W2 wages) will need to be around $40,000 annually.

Engaging a financial advisor before issuing payroll is essential to ensure you are paying yourself the appropriate reasonable compensation. However, it's important to note that payroll plans are flexible. You can adjust your payroll plan depending on your goals and cash flow needs.

The Perks

Less Taxes

More Benefits

Increased Visibility

Health Insurance for Self-Employed

By paying for health insurance through the company as an employee, you can fully deduct the cost of premiums as a business expense. As an officer of the company, it will show up as income on your W2, but the tax savings remain because you will have prepaid the necessary taxes through payroll.

Retirement Savings for Self-Employed

You truly realize the benefits of an S Corp when exploring Solo 401(k) and SEP IRA retirement plans. When opened under the company, these plans will enable you to contribute a portion of your W2 salary to your retirement plan AND allow the company to match those contributions as a business expense. This takes income you would typically pay self-employment taxes on and puts it in a tax-deferred retirement account.

How to Elect S Corp Status

Electing S Corporation status for your business, if you're operating as a sole proprietor, involves several key steps:

Form a Corporation or LLC: First, you need to form an LLC or other legal entity. This is because a sole proprietorship cannot be an S Corp; the S Corp status is a tax designation that applies to corporations or LLCs. You'll skip this step if you already have an entity in place.
Obtain an EIN: Once your corporation or LLC is formed, you must get an Employer Identification Number (EIN) from the IRS for your business entity. This is a requirement for any business that wants to elect S Corp status.
Ensure Eligibility: Before electing S Corp status, ensure that your business meets the IRS criteria for S Corps. This includes having only allowable shareholders (individuals, certain trusts, and estates but not partnerships, corporations, or non-resident alien shareholders), having no more than 100 shareholders, having only one class of stock, etc.
File Form 2553: To elect S Corp status, you need to file Form 2553, "Election by a Small Business Corporation," with the IRS. This form must be signed by all the shareholders.
Timely Filing: The election must be made by March 15 of the current year if you want the election to be effective for the current tax year. If your business is a new entity, you have two months and 15 days from the date of formation to file Form 2553.
State Requirements: Depending on the state your business operates in, there may be additional state-level requirements for S Corp status. Check with your state's department of revenue or a tax professional.
Maintain Compliance: After electing S Corp status, ensure that your business continues to meet the IRS requirements for S Corps. This includes adhering to the rules regarding the number and type of shareholders, stock, and distribution of profits and losses.

Remember, the election of S Corp status is primarily for tax purposes. It can offer tax benefits, such as avoiding double taxation on dividends, but it also comes with specific compliance requirements that must be continuously met.

Questions?

The tax code is overwhelming, and it's not easy to navigate. Nobody is born knowing how to run a business, and it takes time to understand what's right for you. But asking questions is the best first step.

You might want to run your business as an S Corporation for tax purposes, the next-level benefits it can offer, or the better visibility into your business financials. Either way, we invite you to contact one of our Business Consultants for a complimentary business evaluation to see if it's the right fit for you.

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