LLC or S-Corp - Which One is Better for Me?
Hi Ladies, I am Orumé, a business owner. Growing up I never imagined becoming an entrepreneur. I did not think I had the moxie like my mother who was a successful, international wholesaler. So, after I became a CPA, I was content to be an employee and work solely in the service of my employer.
However, like many folks, when you have a passion for something, or you are really good at something, invariably you become more drawn to it. And so, I became a sole proprietor, and during tax season, I started preparing tax returns on the side. Years later, I went all in and became a full-time business owner.
Sole Proprietorship is the simplest and the most basic type of business. All you need is a service or product for sale, and you are in business. But what happens when you decide you want to make that transition from a side-hustle or hobby to a real business? You need to establish a tax and legal entity that will best serve the goals of your business. Or maybe you started with one structure and now it’s time for you to evaluate if you made the right choice and if you should switch, (and yes although it does require some work, it is possible to change a business structure.)
Two popular business structures
While big corporations and startups that aim to go public opt for C-Corporation legal structures, many small and growth business owners are attracted to the LLC and S-Corporation tax structures. Every business is unique and business owners need to analyze a number of questions in determining their best option.
Here are some factors to consider in determining a business structure:
Who owns the business venture? Is it a solopreneur? Do I need a partner? Might I need investors?
Who will run the business? Will I manage all aspects of the business alone or do I need a board or a management team?
How will the business make money? Is it a service or product based business or a holding company?
How will business profits be allocated if there are multiple owners?
Then you should evaluate these issues:
What is my bandwidth; would I rather focus my time on working on my business rather than processing back office work such as accounting data entry for my business?
Will I be able to meet numerous compliance requirements?
Is cost a factor; do I want to minimize my accounting and tax filing costs?
Do I want to be able to have foreign investors?
Do I need to hire one or more people to help me run my business?
Let’s take a look at a comparison table of the characteristics of two disregarded entities (meaning the business does not pay taxes and the income and tax liability is passed through to the owners.)
Example: advantage to s-corp
After careful evaluation and discussion with Client A, her top two choices are the LLC and S-Corp structures. So which one should she choose? We decided to run some projections and here are the results.
On a net income of $100,000, and a regular LLC entity choice, (files the business tax return on a Schedule C form) Client A pays self-employment tax of 15.3% in the amount of $15,300.
However, as an S-Corp entity, (files a form 1120-S), Client A splits the net income of $100,000 into $60,000 of payroll and $40,000 of distribution. This time she pays self-employment tax on only the payroll portion of $60,000 and now the tax liability is $9,180.00. The distribution of $40,000 is not taxed.
This yields an annual tax savings of $6,120.00, a reduction of 40% in tax liability. Wow! This means instead of paying $1,275 monthly for payroll taxes as an LLC, Client A is paying $510 as an S-Corp which is an approximate savings of about $700 monthly. Her positive cash flow and extra money can be saved to pay income tax, spent on personal or business development, or invested in a retirement vehicle.
Depending on her tax bracket, Client A estimates paying about 20 % for federal and state income tax combined.
Example: advantage to llc
Client B had a different business scenario. She wanted to be able to manage her business with flexibility without having to report to a board of directors, or to hold annual meetings. Additionally, she did not want the obligation of filing a separate business tax return and really wanted to keep things simple; so the option of filing her interior design business tax return with her personal return was really attractive to her (filing on Form 1040 - Schedule C.) Her projection also showed the company operating at a loss for the first five years. This loss was able to offset her income from other sources so the potential tax savings she would have gain if she was a S-Corp operating at a profit was irrelevant. Lastly, Client B’s goal was to open up her business to investors after five years. She envisioned having more than 100 investors, including her foreign grandparents and she did not want to have to allocate profit and losses based on ownership interest but rather based on other attributes per her determination.. These criterias are not available to S-Corps and so we determined the LLC structure to be a better choice for the business.
A cost benefit analysis shows that businesses with higher income and net profit often obtain more tax savings with the S-Corp structure. It is important to keep in mind that the tax savings for a business with lower net profit might not be significant enough to offset the payroll, tax filing and compliance costs associated with an S-Corp entity type (S-corp filing requirement and accounting fees can average $1500-$2000 annually.)
So, which is the best structure for your business? The answer is “it depends" as the choice is not always determined by a desire to maximize tax savings for a business. Even similar businesses can yield different results if there is a change in one or more of the business criteria.
Now for the required CPA disclosure: This information is for illustration purposes only. Please consult a tax professional for advice that is unique to your business scenario.