WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
I often get this request from small business owners I speak to...
"Can you give me a 2 minute tutorial on S Corps, LLC’s, Sole-Proprietorship and some retirement account options from a planning perspective?"
And my answer is always, of course! So I am going to share today what I tell everyone who asks...
First off, we are not CPA’s or Tax Attorneys focusing on business structure. That’s not a boring compliance disclaimer, but its’ actually important to realize that this is not just a tax decision but a legal/protection one.
I’m just helping you to wrap your head around your options and some “on the ground” advice that will give you some perspective.
What Are S Corporations?
S corporations were originally set up so that small business owners wouldn’t get taxed twice on their corporate business income. Prior to the S Corporation election, if a small business owner had a corporation, they would be taxed both at the corporate level and at the personal tax level even if they were the only person involved! S Corps were created for small business owners (less than 100 employees only) to avoid this double taxation problem. Simply put, S Corps are pass through entities which means they don’t have any corporate tax liability…income and losses are “passed through” onto the owner’s personal tax return.
When you become an S Corporation, you are responsible for setting up payroll and paying out W2 salaries to yourself and any employees you may have.
Why do people set up S Corps?
Because it can lower the amount you pay in self-employment taxes. Let’s use an example: you generate $250,000 annually in business income. If you just take that income as normal 1099 schedule C income, you will pay self-employment tax on all of it. But if you set up an S Corp, you will instead pay yourself a W2 salary and then you can take distributions (the profits) out of the business afterwards. The w2 salary will go through the normal tax withholding system (ie: you will pay social security/Medicare tax which is the equivalent of the self-employment tax) but the distributions are exempt. Those distributions are not considered salary income (it’s a profit distribution) and so you will not pay self-employment taxes (or Medicare/social security tax) on that amount.
Now, you may be thinking, well, couldn’t I just take a really low salary and pay myself most of my income as a profit distribution to lower my tax liability? No! That is the number one thing the IRS is concerned about and monitoring when people have S corporations set up. You have to pay yourself a “reasonable” salary considering the nature of your business, your role and responsibilities and what any other reasonable person would be paid in salary for that same job. In other words, you can’t make $400,000 in your business and then pay yourself $50,000 in salary with the hopes of taking the rest as distributions. That is a giant red flag to the IRS.
Should you set up an S Corp for your business?
What’s my take here? S corporations can be an effective tool (again, I’m only speaking as to the tax side of things here) but I do think they can be overused by people and their CPA”s looking to “do something”. They really only make sense to set up once you have enough income that the tax savings warrant it. The cons? They can be costly to set up & maintain, you now have to manage payroll and two sets of books, you have to file a corporate tax return (yes it’s pass through but you still have to file). I’ve seen people set up an S Corp before it really made sense to do so and now they have this whole separate headache in addition to running their business, and they probably would have given back the tax savings to not have to go through that process (because again the tax savings are only on the distribution portion and in some businesses it’s going to be really tough to show a “salary” that much lower than your total compensation).
For a small business making a certain income (greater than $150k-200k+) it’s absolutely worth exploring the S Corp, and it may prove to be super effective, I just don’t want to paint it as the holy grail to all people!
What is an LLC?
LLC’s are a bit more straightforward to explain. First off, similar to filing as an S Corporation, LLC’s are pass through entities- all of the business income (deductions, losses and other tax items) flow through to the business owners personal return (A multi-member LLC is taxed like a partnership, with it’s income passing through to all the members.) The difference is that all income flowing through the LLC is subject to self-employment taxes…there is no opportunity to save on employment taxes.
What are the benefits of an LLC over an S Corp?
LLC’s are chosen over S corporations because they are a lot more flexible to set up & to maintain than a corporation. They provide many of the same legal protections as a corporation without all of the restrictions & maintenance that an S corporation will involve. Many businesses that are just getting off the ground or are planning on remaining relatively small will set themselves up as an LLC for legal & protection reasons without having to worry about the added details that an S Corp will provide.
From a tax standpoint, there is no tax difference between having unincorporated Schedule C income and having that income flow through the LLC. Again, many of the reasons that people incorporate and set up an LLC or partnership are outside the realm of tax, but it is super important to discuss with your CPA and Attorney.