If you’re the sole proprietor of a business or you work as a freelancer, you are your business. There is no need to set up a legal structure or decide on a tax election (more on those in a minute.) You file your business taxes with your personal tax return under your own Social Security number.
When your business grows and takes on partners and/or employees, formalizing your business with its own Federal Tax ID number can help you take advantage of tax benefits and liability protections owning a business may offer. Moreover, you may choose to avail yourself of these benefits even while still a sole proprietor with no employees other than yourself.
Which tax benefits and protections your business receives and which requirements and restrictions it incurs then depends on the business structure and tax election you choose.
Two of the most common business structures for small businesses are LLCs and S Corps.
The Difference Between LLCs and S Corps
An LLC, or Limited Liability Company, is one of the legal structures for a business or “business entities” you can choose when forming a business. What distinguishes LLCs from other business entities is that they separate your business assets from your personal ones. In this way, an LLC protects your personal assets from being taken to cover the business’s liabilities.
Other possible legal structures for your small business include a partnership and a corporation.
An S Corp, or S Corporation, is not a business entity but a tax election for a business. It determines how that business is taxed both federally and on a state level.
Since one is a business structure and the other is a tax election, you don’t have to choose between the two when you set up your business. In fact, you would need to form an LLC (or other business structure) before choosing for the IRS to tax that business as an S Corp.
How the IRS Taxes LLCs and S Corps
While an LLC is a business structure and an S Corp is a tax election, the two are taxed differently unless you specifically elect otherwise. We’ll explain:
How the IRS Taxes LLCs
If you own a single-member LLC, the IRS taxes you as a sole proprietorship. That includes a Federal Insurance Contributions Act (FICA) tax, commonly known as a self-employment tax, that you pay on all the taxable income your business earns. In addition, you’ll pay personal income taxes at a tax rate based on your tax bracket.
The risk with this combination of tax burdens is that if your LLC earns higher profits than the reasonable compensation you would pay yourself, your tax bill could be unnecessarily higher.
If you co-own an LLC with other members, then the IRS taxes the business either as a corporation or partnership, depending on its qualifications. To be taxed otherwise requires a specific and deliberate tax election.
How the IRS Taxes S Corps
By contrast, the IRS taxes S Corps by passing down the business’s earnings, losses, credits, and deductions to shareholders. This is for federal tax purposes only; how the state taxes an S Corp depends on the state. Charlotte accountants can tell you what the tax rate is for LLCs and S Corps in North Carolina.
An LLC Taxed as an S Corp
The exception to the general rule described above is to have your small business CPA request that the IRS tax your LLC business entity under the S Corp tax election. This typically reduces your tax bill by adjusting how you pay taxes on various income segments.
A Single-member LLC Taxed as an S Corp
If you own a single-member LLC and you elect for the IRS to tax it as an S Corp, your business would pay you a salary qualifying as “reasonable compensation” akin to what you’d earn if you were any other employee in the same role. (Note that, in nearly all cases, you must take a salary appropriate for your job as an employee-owner of an S Corp.)
As an employee-owner of a single-member LLC, the IRS taxes as an S Corp. You would then personally be responsible for paying half of the business’s payroll taxes and personal income taxes on your salary, as well as a Federal Unemployment Tax Act (FUTA) tax, or unemployment tax. The business, then, would pay the other half of the payroll taxes, though a tax accountant would then be able to write it off as a deduction. If you earn any other profits, you could then exempt them from payroll taxes as distributions.
In short, electing for the IRS to tax your single-member LLC as an S Corp lowers the proportion of your income subject to self-employment taxes.
Benefits and Drawbacks of Having Your LLC Taxed as an S Corp
An S Corp typically lowers your corporate taxes by allowing you to pass your business tax burden to shareholders to file on their individual tax returns and eliminating the risk of double taxation. It also extends your limited liability and exists in perpetuity, even if you leave or pass away.
However, an S Corp can also be more complex to set up and maintain. Compliance regulations are stiff for tax filings and payments, and failure to comply could lead you to lose S Corp status. There’s also an investment cost in incorporating as an S Corp.
As an employee-owner of an S Corp, you must pay yourself a regular paycheck, then deduct payroll taxes from that check throughout the year. In addition, your business must pay quarterly estimated taxes. Fortunately, you can have most of this handled for you by employing the services of a qualified CPA for small businesses.
What Are the Tax Rates for LLCs and S Corps?
To find out the current tax rates for LLCs taxed as sole proprietorships and LLCs taxed as S Corps, ask your small business tax advisor.
How Can I Form an LLC or Convert My LLC’s Tax Status to an S Corp?
The process of forming an LLC varies from state to state. Typically, it requires choosing a business name, filing articles of organization, choosing a registered agent, and producing an operating agreement. To convert your LLC to an S Corp, you must first meet specific requirements, including (among others):
- Being a domestic corporation
- Having no shareholders qualifying as corporations, partnerships, or nonresident aliens
- Having fewer than 100 shareholders
- Having just one class of stock
If you meet all the requirements, you must file IRS Form 2553, “Election by a Small Business Corporation.” While this may sound involved, qualified Charlotte accountants can help you do all of it.
How to Set Up, Maintain and File Your Business Taxes as an LLC or S Corp
Although CPAs in North Carolina cannot form an LLC for their clients, Scott Boyar is a trusted Charlotte, NC small business CPA with training as a tax accountant for LLCs and S Corps alike and can assist with any tax questions or concerns. Top among Charlotte accountants, let Scott Boyar be your new small business tax advisor and discover how to pay the least in business taxes while avoiding penalties.
