What is an S Corp? Is it time for my small business to elect?

Whether you are just starting a new business, taking a side hustle a little more seriously, or have been in business for a while, you’ve probably heard a lot of business jargon. And you’ve probably spent some time figuring out what makes the most sense for you and your business. The answer never seems that clear and can depend on a few factors. Follow along for a bit of a breakdown of the most common business structures, the advantages of each, and when it may be time to make some entity changes!

First and foremost, if you’re a business of one or just starting out, there are probably 3 main terms you’ve heard of. You’ve probably spent time looking up an S Corp vs an LLC. If you haven’t, don’t fret, we’ll go through each below!

Sole Proprietorship

A sole proprietorship is the most basic and straightforward tax structure. It is essentially the default tax structure created when an individual starts earning self-employment income. There are no elections, no special filings; if you take no other action with your business, you essentially create a sole proprietorship. You are the sole owner, and your business is unincorporated. There is no tax or violation issue with this setup; many businesses operate as sole proprietorships.

Limited Liability Company (LLC)

An LLC is often the first type of business entity that a small business or solopreneur thinks to set up, and rightfully so. This is one of the easier business entities to establish and provides a few benefits above a sole proprietorship. We will discuss all the major differences between entities in the next section! To form an LLC, a business usually must first register and apply through their state’s Secretary of State. You can look up each state’s individual filing requirements. Still, most states allow you to apply online with some basic information. Depending on your state, there is often a filing fee, and you will need an address, your name, and other basic information to file the LLC application.

S Corporation

And finally, the most complex of the three, an S Corp. S Corps can be a little tricky to understand because it is not a separate business entity, like an LLC. An S Corp is merely a tax election that can be made by certain qualifying business entities. And you guessed it, an LLC is a qualifying business entity that can elect to be taxed as an S Corp. The S election simply updates how Federal and State tax authorities recognize the business in terms of how it is taxed. If you already operate a single-member LLC, you can easily make an S Corp election. This election completely changes how your business income and expenses are reported and taxed, so be sure you understand this before making any elections.

So, all that sounds great, but what does that actually look like? What are the main tax and legal differences between these three? Keep reading for more details on the tax treatment of all 3 and some of the pros and cons of each.

Taxation

Essentially, a sole proprietorship and a single-member LLC are taxed in the same way. At tax time, there is no separate filing. You simply report all business income and all business expenses on a special schedule (Schedule C) and attach it to your regular individual income tax return (Form 1040). Any business profit or loss flows through to your individual tax return and is included with any other regular income you may have (from a full-time salaried job, investments, etc.) You calculate and pay self-employment tax (15.3%) on your taxable self-employment earnings. You also pay Federal income tax, which is based on all of your taxable income (that includes self-employment earnings, plus any other income you report). How much you pay in income tax is based on your tax bracket. This is settled through your individual income tax filing. There are a number of free self employment tax calculators available online that can help you estimate your tax based on your income and expenses.

On the other hand, an S Corp is a little more complex. Once an S Corp election is made, the business will no longer report business income and expenses on a Schedule C attachment. Instead, the business income and expenses are reported on their very own tax filing report (Form 1120S) that must be filed with the tax authorities. The 1120S filing generates a K-1 report for the business owner, which reports the S Corp’s profits or losses that will flow-through to you, the owner’s, individual tax return (Form 1040). Additionally, S Corps require business owners to become employees of their business. This means they can pay themselves an annual salary through recurring payroll throughout the year. At the end of the year, the business owner would receive a W-2 from their own business. The main thing to consider is that only income paid out as a salary would be subject to payroll taxes, which is the same amount as the self-employment tax (15.3%) mentioned above. The owner’s W-2 salary and the employer portion of the payroll taxes are tax deductible expenses of the S Corp, which lowers its overall profit. This is a good thing, because the S Corp’s  profit (or loss)  flows through and is ultimately taxed on the business owner’s individual income tax return. But the income is not subject to self-employment tax. It is just taxed at Federal income tax rates based on the business owner’s regular tax bracket. This is a considerable tax saving for businesses that are generating substantial profits.

Other Pros/Cons

So, it’s clear an S Corp can create tax savings – especially for business owners generating substantial income, but what else is there to consider?

1. Legal Protection

An LLC/S Corp is usually recommended for business owners seeking extra legal protection. When an LLC is formed, there is a clear distinction between the business and the business owner. For many, an LLC and/or an S Corp is essential as it creates liability protection for the business owner’s personal assets (in most cases). As a sole proprietorship, any personal assets are technically at risk if you were ever sued or owed debts due to your business dealings. An LLC/S Corp creates liability protection for business owners as individuals when working in their trade.

2. Complexity

Although a sole proprietorship does not offer the same legal protections as an S Corp, it is simpler to set up and maintain. S Corps will require monthly or biweekly payroll and a separate tax filing. You should consider what stage your business is at, how much it is making, and how much time or money you are willing to put into record and bookkeeping required for a more complex structure such as an S Corp. Meanwhile, an LLC provides legal protections while maintaining a more straightforward structure.

S Corp Specifics 

So, you’ve done the LLC vs S Corp analysis and decided that you are ready for an S Corp election. There are a few more things you should be aware of.

• Do I have to take a salary as a business owner?

We mentioned earlier that you can pay yourself a salary as the business owner and only this salary amount is subject to that pesky 15.3% for self-employment or payroll taxes. If you’re thinking, that sounds great, I’ll take a super small salary to avoid this tax, think again! You are required to take a salary, and you are also required to take a salary that is considered reasonable. This is somewhat vague, but you will want to make sure you are paying yourself a salary comparable to what you would earn working an equivalent job for another employer. Several websites can help you estimate reasonable salaries based on your physical location, job title, hours, etc.   

•  How do I make an S Corp Election?

The first thing you need to do is make sure your existing business entity qualifies. If you have a single-member LLC, you should be all set! You can then file form 2553: “Election by a Small Business Corporation.”

•  Will I pay less in taxes if I make an S Corp election?

Generally speaking, S Corps usually have lower tax bills than their LLC equivalents. Without looking at each business’s unique circumstances, there is never a way to guarantee this. Still, if your business is making more than what you would be reasonably earning at a similar job with another company/employer, it is likely that an S Corp election is going to benefit you and save you money at tax time. 

If you are wondering if it is time to switch your sole proprietorship to an LLC, the answer is probably yes. Once you begin earning a full time or a part time wage from your business, you will want some extra legal protections, not to mention an LLC looks even more professional if you are working with clients or vendors. If you are unsure if you are ready to make an S Corp election for your LLC, be sure to understand what the tax savings can look like but also understand the additional complexities that will come from the ongoing upkeep of your S Corp books and the extra complexities during tax filing season. If you are making a full time living from your self-employment income, it is likely you are ready for the switch, though! 

Need more help with registering your business?

Check out A Freelancer’s Guide to Taxes, a comprehensive course on how to lower your taxable freelancing income, curated by Brianna Zell, CPA.

Alex Fasulo, LLC and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for educational and informational purposes only. It is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors prior to making any tax or business election or decision.