Are you thinking about starting a business? Starting your first company is a thrilling experience. Along the way, you’ll meet challenges and pitfalls that you’ll need to overcome. For those entrepreneurs that do manage to make it work, they can look forward to the reward of handsome profits on the company’s bottom line.
However, as a business, you need to pay taxes on your profits. If you fail to give Uncle Sam his cut of your earnings, it could wind up with you going to prison for Federal tax evasion. Fortunately, the federal government wants to make it easy to do business in America.
Therefore, as a business owner, you get the advantage of capitalizing on tax breaks offered by the government to stimulate business growth, which in turn grows the economy.
However, these tax breaks are only valid for business owners that operate a structured legal entity. Some of the most popular entities used when founding a b8usiness are an S-Corp and an LLC.
So, what’s the difference between the two entities? Should you register an S-Corporation, or form a Limited Liability company? In this article, we’ll unpack the differences and similarities of both, allowing you to make an informed decision when formalizing your business.
Anyone Can Register an S-Corp or LLC
According to the Registrar, anyone can open a business in America. The only thing stopping you from finding out how is researching the topic. For recommended reading, we suggest you visit the usa.gov website and review the information on offer.
You don’t need any previous business experience when opening an S-Corp or an LLC. IF you’ve had financial problems in the past, a bankruptcy filing won’t prevent you from opening a business. However, if you did file for bankruptcy, it might affect your company’s ability to get a credit line.
Applying for your business entity is a simple process, and there are plenty of accountants that you can use to help you file the paperwork. Since you’re going to need an accountant’s services when running your company, now’s a good time to find a reputable CPA that can help.
The Federal Government Wants You to Open a Business
Small business growth is the backbone of the United States economy. The government works with the IRS to set up a tax code that benefits the people and business, rather than its interests. As a result, the tax code offers businesses like S-Corps and LLCs tax break incentives.
These tax breaks help you conserve your company’s profits, adding more to your bottom line every filing season. The government understands that if your company is doing well, it has a trickle-down effect on stimulating the economy, driving growth, and that’s what the government wants – growth.
So, what are the benefits of owning an LLC and an S-Corp?
Tax Benefits for an LLC
When you formalize your company as an LLC, you get the following benefits from the federal government. An LLC is a simple and straightforward way to open a business and get things rolling.
- Pass-through Taxes – LLC owners don’t need to file corporate tax returns to the IRS. In this case, the owner merely reports the company’s profit and loss on their individual tax return. This procedure prevents double-taxation where you would have to pay taxes on your business income, as well as taxes on your individual tax return.
- Legal Protection – A LLC is a separate legal entity from the business owner. Therefore, you’re not personally liable for any of the business debts. If your company goes under, then the sheriff can’t seize your home or personal assets to repay your creditors.
- Reduce Expenses – As an owner of an LLC, you get to write off some of your lifestyle expenses through your company. The government allows you to write off a portion of expenses like dinners and hotel bills as business expenses. You can also write off other operating costs like your cellphone and rental for your business address.
If You Don’t Turn a Profit – You Don’t Pay Tax
One of the best reasons for owning an LLC is that if you don’t make a profit, there’s nothing to pay in taxes. Some businesses take two or three years to turn a profit, and the government is well aware of this problem with startups.
Therefore, you can offset the losses the business occurs in its startup phase against the profits it makes when it starts to turn the corner into a going concern. You can count these losses against your personal income, and drop your tax bill.
It’s important to note that the IRS and the government will only allow you to file a loss on your tax return for three years. After this stage, the government starts to view your business as a hobby, not a going concern, and you’ll have to go back to paying the individual income tax rate.
S-Corp Vs. LLC
Both S-Corps and LLCs have some similarities and some differences that set them apart from one another. When choosing between the right entity, it’s vital that you make your decision based on what’s right for the structure of your business.
If you’re having trouble with deciding on the best entity for your company, speak to your accountant for advice. Your accountant will walk you through the reasons why you should choose one or the other, based on your company and individual needs.
What are the Similarities Between S-Corps and LLCs?
Both entities offer the business owner limited liability. If the business goes under, then the owner has no liability. Therefore, the owner does not have to worry about the sheriff foreclosing on their home or seizing their assets.
S-Corps and LLCs are both separate legal entities that come into existence through a filing with the state.
Both S-corps and LLCs also benefit from pass-through taxation laws. However, S-Corps must file a corporate tax return while an LLC only needs to worry about filing a corporate return if there is more than one owner of the business.
Both LLCs and S-Corps are subject to any state-mandated requirements, such as paying fees and filing their annual reports.
What are the Differences Between S-Corps and LLCs?
There are some significant differences between S-Corps and LLCs as well.
- Members – LLCs can have an unlimited amount of members, whereas an S-Corp must have fewer than 100-shareholders.
- Residency / Citizenship – LLCs don’t require members to be U.S citizens or residents, whereas S-Corps do require shareholders to be U.S citizens or residents.
- Self-Employment Tax – S-Corps have better self-employment tax advantages. Owners of S-Corps can claim a salary through the company, paying FICA taxes on the total salary amount. Owners of S-Corps can also treat corporate earnings after salary as unearned income, and that income is not subject to self-employment taxes.
Where S-Corps can be Beneficial for Business Owners
Self-employment taxes are where the business owner can gain tremendous benefit from opening an S-Corp instead of an LLC. However, if you’re only starting your company now, then consider going with an LLC first, then make the switch to an S-Corp later down the line.
If you’re a business owner involved in a practice like consulting where your income is directly tied to the hours you work, then its best to keep your company as an LLC. However, if you don’t have this issue of trading time for income, then you can switch to an S-Corp and reap the tax advantages.
It only makes sense to switch to an S-Corp if your company is earning a significant amount of money, which is usually over $100,000 per annum. If you’re running a full payroll, then it’s time to switch to an S-Corp.
Is It Better for a Self-Employed Person to Register as an S-Corp or LLC?
With S-Corp owners, you can pay yourself a “reasonable salary.” All the income you make above that salary counts towards a distribution that saves your Medicare and Social Security taxes, which effectively works out to a 15% saving on your tax bill.
You might find yourself wondering – What is a “reasonable salary?” There’s plenty of debate around this issue, and there are no concrete guidelines on offer from the IRS or federal government. When it comes to setting your salary, it might be a wise idea to do what others do, and index it with Glassdoor or PayScale.
What Is the Tax Rate for Self-employed Individuals?
As a U.S resident or citizen, you have to pay taxes on all of your total net earnings every year during filing season. Fail to pay, and you could end up losing your company to the taxman. The key thing to note is that you have to pay taxes on your “net income.”
Therefore, you can subtract a significant amount of expenses from your return, lowering your tax bill in the process. For self-employed individuals, the official tax rate is 15.3%. The tax rate also consists of two parts; 2.9% for Medicare, and 12.4% for Social Security.
The government caps the Social Security portion of the tax rate, which it sets each year. If your net income exceeds the maximum for that year, then you’ll continue to pay the Medicare portion of the SECA tax requirement.
Comparing Tax Benefits of LLC or S-Corp to W-2 Employees
The 2018 Federal tax rate for a $100,00-income through a joint filing was 22%. The state tax for the same couple is an additional 5.53%.
In this scenario, the W2 employee ends up paying a total tax rate of 27.53%, excluding deductions. A self-employed person would have a total tax responsibility of 15.3%. This figure alone should be incentive enough to start a business and formalize a company as soon as possible.
Retirement Benefits for Business Owners
Employees get the benefit of a 401(k) plan and an IRA. However, business owners – what’s in it for their retirement? It might sound crazy, but the retirement benefits for business owners are also better than for employees.
The SEP IRA
The SEP IRA is a massive loophole in the tax code that benefits business owners. The government realizes business owners don’t have access to a traditional or Roth IRA, and there’s no 401(k) when you own the company either.
The SEP IRA has a huge contribution limit when compared with a traditional or Roth IRA. With a Roth IRA, you have an annual contribution limit of $6,500. That’s a considerable amount of money that the employee can tuck away each month.
However, the business owner can contribute up to $53,000 per year to their SEP IRA, and they also benefit from more flexibility than a traditional or Roth IRA as well. The IRS allows business owners to deduct the full $53,000 in contributions from their taxable income as well. That saves you a bundle when it comes to tax time – the government is literally helping you fund your retirement, tax-free.
Wrapping Up – Get Started
After reading this guide to LLCs and S-Corps, you should be ready to start your company and formalize it as soon as possible. If you want to maximize your rebate from the taxman and reduce your total tax bill, then registering as a self-employed individual is essential.
The total tax savings from registering your company formally with the registrar are a no-brainer. As a business owner, one of your top priorities is to reduce the amount of taxes you pay the government. Strangely enough, the government also incentivizes this practice, and it’s not like you’re cheating anyone out of income.
As a business owner, you help to grow the economy and provide jobs. The government believes that you deserve a tax break for your efforts, so take advantage of it.
When it comes to selecting an LLC or S-Corp, the answer depends on the size of your company and how many employees you have. If you have a decent staff compliment, multiple owners, and plenty of profits, then consider registering as an S-Corp, everyone else can benefit from formalizing as an LLC. Speak to your accountant for the right advice.