Why S-Corps Are Better than LLCS

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 developed a playbook to help small business owners take advantage of the same tax savings corporate America enjoys while remaining independent.

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 pass to the owner(s), who become 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 need excellent bookkeeping practices as well and a way to issue payroll for yourself.

How It Works

While S-Corps 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 the business 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-Corp Stacks Up

What’s the Difference Between an S-Corp and LLC?

LLCs are a go-to structure for small businesses. Both are pass-through entities and 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-Corps, but their financing options and potential for growth are limited.

What’s the Difference Between an S-Corp and C-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-Corp 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?

Perhaps the easiest way to think of running an S-Corp 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’ll be able to 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.

S-Corps 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-Corp 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 be 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.

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. We invite you to contact one of our Business Consultants for more information or view some of our resources below.

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