In 2023, a survey found that 37% of small businesses and gig workers surveyed had anxiety and confusion about how to file taxes. Your own income taxes can already be confusing enough, and when you add business ones, it can be terribly complicated.
One way to prevent this from happening is to understand what your business structure choices are before jumping in. One popular choice is the limited liability company (LLC), so we’ll go over what that is, as well as what an S corporation is. Then, we’ll explain S corp vs LLC tax benefits so you’re better informed as a business owner.
What’s an S Corporation?
The main thing you should know about an S corporation is that there’s actually no such entity or structure type. Instead, it’s a tax election by the IRS.
This means that you can technically have an LLC (more on this later) and elect to be taxed as an S corp. You can also do this if you own a corporation, such as a C corporation.
To make your business an S corp, you can do so by filing IRS Form 2553.
What’s an LLC?
A limited liability company is a type of entity or business structure.
Many small business owners and entrepreneurs like this option, as its main advantage is the separation of owner and business liabilities. For example, if your LLC goes into debt, your own assets wouldn’t be at risk.
Tax Benefits of an LLC
Since an LLC is an actual business structure, we’ll start with its tax benefits first. Then, we’ll examine the tax benefits that come with an S corp so you can decide if you want to opt for that tax election.
Flexibility in Taxation
By default, LLCs are taxed as pass-through entities, which means the profits “pass through” the company onto the owners. This means that the money you earn on your LLC is taxed at your individual tax rate. This will help you avoid double taxation.
On top of that, you won’t pay a corporate tax for your company either.
Simplicity in Management
LLCs typically have fewer administrative requirements and less stringent formalities compared to S corps. They’re easier to manage, so if you’re looking for something simpler, then you might want to keep your LLC’s default tax status.
Flexibility in Profit Allocation
LLCs can allocate profits and losses among members in a flexible manner. As a result, you can have customized distribution arrangements among owners.
Tax Benefits of an S Corp
The tax benefits you’d receive from an LLC in its original state can already be wonderful. But in some cases, an LLC taxed as an S corp can offer you more advantages. Here are some points to consider.
Self-Employment Tax Savings
One of the biggest benefits you can get for an S corp tax election over the default tax election for LLCs is it allows you to avoid some amount of self-employment tax.
In 2024, the self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare) for the first $160,200 of your income. If you made your LLC an S corp, and you made $168,000 in net profit, then you can officially pay yourself a salary of only around $40,000. You’d then only pay 15.3% self-employment tax on that, and the rest you’d pay ordinary income tax rates.
For smaller businesses, an S corp tax election is a good idea; however, once you go over a certain threshold in income, it won’t make much of a difference. Larger companies making large sums of money can’t reasonably justify a low $40-50k salary, so you’re going to have to pay at or above the tax threshold of $160,200 anyway, meaning you’ll pay 15.3% on that first $160,200 profit.
Deductible Fringe Benefits
When you have an S corp tax election for your LLC, you’ll enjoy deductible fringe benefits. This means you may be able to offer things like health insurance and retirement plans to your employees. As a result, you can make your company a more attractive place to work, and you’ll have a leg up on your competition.
Disadvantages of an LLC Taxed as an S Corp
While the S corp election certainly comes with its pros, it’s not without its cons either. Below are the main disadvantages you should keep in mind.
Salary Payments
If you keep your company as an LLC, there are no salary requirements. However, if you make it an S corp, you’ll have to pay yourself a salary as the owner. In addition, you’ll have to pay your employees salaries.
Extra Costs
Because you have to deal with employee salaries, you’ll have the added burden of payroll tax withholding and payroll tax filing. This increases your regulatory compliance, so it’ll cost you more with a CPA or accountant to handle your payroll tax filings.
More Restrictions
S corporations have restrictions on ownership, such as limits on the number and type of shareholders. For instance, S corps can’t have more than 100 shareholders, and they must all be US citizens or residents.
Plus, you can only have one class of stock. This will limit the flexibility for structuring ownership and distributing profits among shareholders.
Potential Loss of Entity Characteristics
Converting to an S corp may result in the loss of certain characteristics that LLCs offer. For example, you may lose the ability to have different classes of ownership interests and flexible profit distributions. In addition, the less stringent ownership and management requirements will go away too.
Complexity of Conversion
As we’ve mentioned earlier, you’ll have to file paperwork with the IRS to change your LLC to an S corp. That’s not it either.
You’ll potentially have to make changes to your company’s operating agreement and ownership structure. This process can be complex and may require professional assistance.
Also, converting to an S corp may have state-specific implications, including changes in tax treatment, filing requirements, and compliance obligations. It’s essential to consider the state laws and regulations governing S corps in your jurisdiction.
Know the S Corp vs LLC Tax Benefits
Hopefully, you now have a better understanding of the S corp vs LLC tax benefits.
If you want to start your own business, then it’s always a safe bet to start off by forming an LLC. Once you get a better understanding of your business operations, then it may be ideal to opt for an S corp tax election.
Should you have any doubts, consult with tax advisors and legal professionals. That way, you can ensure that the conversion is the right choice for your specific circumstances.
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