LLC vs S-Corp: Which Business Structure Is Best for Tax Savings and Protection?

As a small business owner, choosing the right business structure for your company is one of the most important decisions you’ll make. The most common legal structure that protects small business owners is the Limited Liability Company (LLC). The main benefit of starting an LLC is the legal protection it provides by ensuring that owner liability is limited to the business for anything that happens within the business.

In this article, we'll explore the fundamentals of the tax structures of LLCs, and when and if it would be advantageous to elect to become an S-Corporation. By the end, you'll have a clearer understanding of how to optimize your business structure for tax efficiency and legal protection.

What is an LLC?

An LLC is a business structure that provides liability protection to its owners (called members) while allowing for pass-through taxation. Pass-through taxation means that the LLC itself does not pay income tax. Instead, profits and losses are passed through to the individual members' personal tax returns.

For example, if you are the sole owner of an LLC with a default taxation structure and make $100,000 in profit in the year, you report that $100,000 on your personal tax return. You will pay taxes based on your personal tax bracket as well as self-employment taxes. Additionally, the LLC structure helps protect the personal assets of its members from business liabilities, such as lawsuits or debts.

One of the most attractive aspects of an LLC is its flexibility. LLCs can be managed by the members themselves or by hired managers, and they can be treated as a sole proprietorship, partnership, or corporation for tax purposes.

What is an S-Corp?

An S-Corp is a tax designation granted by the IRS. It's important to note that an S-Corp is not a separate business entity like an LLC or a corporation. Instead, it is a tax classification that allows the business to benefit from certain tax advantages. The main benefit of electing S-Corp status is that it allows the business to avoid self-employment taxes on a portion of its income.

Self-employment tax (which is essentially the Social Security and Medicare tax) is typically applied to the total net income of a business owner. However, with an S-Corp, you can pay yourself a reasonable salary and distribute the rest of the profits as dividends. Dividends are not subject to self-employment tax, which can lead to substantial tax savings.

To qualify for S-Corp status, the business must meet specific criteria, including having no more than 100 shareholders, all of whom must be U.S. citizens or residents, and having only one class of stock.

LLC vs S-Corp: Key Differences for Small Business Tax Purposes

While both LLCs and S-Corps offer limited liability protection and pass-through taxation, the difference lies in how income is taxed, as well as compliance and formalities.

1. Self-Employment Taxes: LLC owners who are actively involved in the business must pay self-employment taxes (around 15.3%) on all the business’s income. In contrast, an S-Corp owner only pays self-employment tax on their salary, not on the profits that are distributed as dividends.

   
   

2. Salary vs. Distributions: With an S-Corp, you can take a "reasonable salary" (which is subject to payroll taxes) and then take the remaining profits as distributions. The distributions are not subject to self-employment taxes, potentially saving you a considerable amount in taxes. On the other hand, an LLC owner pays self-employment tax on all profits, regardless of whether they are taken as a salary or distributions.

   
   

3. Formalities and Compliance: S-Corps have more stringent operational requirements than LLCs. For example, S-Corps must issue stock to shareholders, hold annual meetings, and record meeting minutes, which can create extra administrative work. Costs for tracking owner’s basis and tax returns also go up when making this election. LLCs have fewer formalities and can be more flexible in their operations.

   
   

4. Separation between Owner and Employee: Owners who make a habit of mixing personal and business expenses should be cautious with an S-Corp as you are treated as an employee first, not an owner. If you pay expenses with the business card, the amounts need to be reported in your wages, and you must personally pay taxes on fringe benefits of using the company card. The costs of hiring someone to keep up with these expenses can become a concern, especially if the business is audited by the IRS.

   
   

When Should an LLC Elect S-Corp Status?

Many small business owners operating as LLCs may wonder when it makes sense to elect S-Corp status. The key factor to consider is whether you can benefit from the self-employment tax savings that S-Corp status offers.

Here are some qualifications and considerations in which it might make sense for an LLC to elect S-Corp status:

1. When Your LLC Is Making a Profit - If your LLC is profitable and you’re paying yourself a draw, you’re paying self-employment taxes on all of the business’s profits. This can add up quickly and eat into your income. By electing S-Corp status, you can take a portion of your earnings as distributions, which are not subject to self-employment taxes. This can result in significant tax savings. To maximize the S-Corp election, the business should wait until making at least $100k in profit. This allows you to take advantage of the tax savings of not paying self-employment taxes on wages, as well as still being able to take advantage of the 199A business deduction.

   
   

2. When You Want to Reduce Your Self-Employment Taxes - One of the biggest advantages of an S-Corp is that only your salary is subject to self-employment taxes. If your LLC’s income exceeds a certain threshold, electing S-Corp status could reduce your overall tax burden. For example, if your LLC earns $150,000 in profit, you can pay yourself a reasonable salary (say $80,000) and take the remaining $70,000 as distributions, avoiding self-employment tax on the $70,000. An example of this tax savings scenario is found below for a business which makes $100k a year:

   
   

   

   
   

3. When You Meet the IRS Requirements - To elect S-Corp status, your LLC must meet specific IRS requirements, such as having fewer than 100 shareholders and having only one class of stock. If your business meets these criteria, electing S-Corp status may be an option worth considering.

   
   

Costs and Considerations of Electing S-Corp Status

While there are tax savings associated with an S-Corp election, there are also additional costs and administrative tasks to consider.

1. Increased Complexity: An S-Corp requires more administrative work compared to an LLC. You’ll need to file additional paperwork with the IRS (Form 2553 to elect S-Corp status) and comply with other corporate formalities like issuing stock, holding meetings, and ensuring all expenses are properly accounted for and anything personal is taxed back to you, the employee. This leads to higher legal and accounting fees due to the increased formalities.

2. Reasonable Salary Requirement: The IRS requires S-Corp owners to pay themselves a "reasonable" salary. If you don’t pay yourself a reasonable salary and instead take most of the profits as distributions, the IRS may reclassify the distributions as salary and impose penalties. Be sure to consult with a tax advisor to determine what constitutes a reasonable salary.

3. State-Level Considerations: Some states may impose additional taxes or fees on S-Corps. Illinois charges a 1.5% replacement tax on the profits from an S-Corp. Make sure to check your state’s regulations to determine how they will affect your decision.

   
   

How to Make the S-Corp Election

To elect S-Corp status, you'll need to file IRS Form 2553, "Election by a Small Business Corporation," with the IRS. You must file this form within two months and 15 days of the start of the tax year in which you want the election to take effect. Once your S-Corp

election is approved, it will apply to the current and future tax years.

Conclusion

Choosing whether to elect S-Corp status for your LLC depends on various factors, including your business’s profitability, the amount you pay yourself in salary, and your desire to reduce self-employment taxes. If you’re running a profitable business and are ready to take advantage of the potential tax savings, an S-Corp election could be a smart move.

However, there are costs and administrative responsibilities associated with making the election. At Pathfinder Accounting & Tax, we’re able to help you evaluate whether this option is the best fit for your business. With careful planning, you can make the most of both your LLC structure and S-Corp election to optimize your business’s tax situation and financial success.