Written by Luke Frye
Photo by Imani Clovis
Can you save money setting up your business as an LLC? Should you elect to be treated as an S-Corp?
I get asked these questions a lot by clients who want to maximize their tax savings. I wish there was a one-size-fits-all answer. But the honest the answer is: it depends on a bunch of different factors.
Before you set up shop as an LLC or an S-Corp, here’s a quick rundown of how these two business structures can benefit you and your business.
Income tax savings may be higher with the LLC
Income tax is based on your AGI, or “adjusted gross income.” If you’re a sole prop or single member LLC, you pay income tax on all of your business income. With the new tax law, your income tax may be reduced with the Qualified Business Income Deduction, or QBID 20% deduction. The QBID deduction is generally bigger (all else equal) for a single member LLC than an S-Corporation. The deduction is based on business income. S-Corporation business income is reduced because your salary is taken out and taxed separately.. This means it is less clear when an S-Corporation could save you on your taxes.
But! Payroll tax savings may be higher with the S-Corp
You’ll generally pay payroll taxes or self-employment tax on more of your income as an LLC than you do as an S-Corp. This is because the main savings of the S-Corp for federal taxes is related to payroll taxes. In an S-Corp you only pay payroll taxes on your salary, whereas self-employment taxes in the LLC are applied to higher thresholds.
Here’s why: when you have a single member LLC that has not elected to be treated as an S-Corporation, you generally pay income tax and self-employment tax on your net taxable income. When you have an S-Corporation, you only pay payroll taxes on your salary. The remaining net income that flows through to you is not subject to self-employment or federal payroll taxes.
Say you generate $200k in revenue and have $100k in expenses, not counting paying yourself. In an LLC that’s not an S-Corp, you have to pay income tax and payroll taxes on the whole $100k. If you’re an S-Corp, you can set your salary at say $50k and only pay payroll taxes (the same as self-employment tax) on that part, and income tax on the full $100k. This savings can often be $7500 or more, depending on your situation. This also doesn't take into account the QBI deduction that would generally be bigger if you’re not an S-Corp.
S-Corps require heftier, sometimes pricey accounting software (bookkeeping, payroll)
More things! If you’re an S-Corporation, you won’t be able to get away with light duty expense tracking software for bookkeeping. You need an actual accounting software that provides for reconciling accounts (ensuring balances match and all the transactions are in the books). You also need to have payroll if you’re making money. That means you need to pay for these things. Gusto starts at $39/month plus $6 per employee. That alone is an additional $540 per year just for payroll.
S-Corp tax-return compliance is more expensive and time-consuming
The S-Corp business structure can make business planning and tax savings easier. But you need to take into consideration your other obligations before you get too excited about this option.
For example, if you’re an S-Corp, you’ll need to file (and pay for) an additional tax return every year.
As opposed to a disregarded entity that you report on your Schedule C of your personal income tax return, you report S-Corporation activity on an 1120-S, a separate flow-through tax return. This typically costs more than an individual return as they’re more involved filings. So, not only does your tax savings need to make up for the additional payroll and bookkeeping software, but also the tax filing which can easily cost $1,500 to $3,000.
Hate doing financial admin? Think twice before setting up an S-Corp.
An S-corporation is kind of like a fancy watch. There are more features, it can do neat things, but also requires more upkeep. If you hate doing your bookkeeping and taxes and all things involved, you may not want to set up an S-Corporation simply because you’ll save money. Think about your time and your energy related to the entity. If your net savings after additional costs is $1,000 a year but you need to spend 10 hours more a year on accounting, are you ok with that? What do you value your time at? Will you avoid taking care of the essentials?
You also need to be ready to work with a CPA or highly qualified tax person throughout the year, not just in April. They can help you monitor your wages, income and distributions, and other bookkeeping issues that pop up. You’ll be surrendering some of your flexibility by setting up an S-Corp, and you may not be saving that much after the fact.
So, what’s better for you?
An LLC can be a great option to provide for some liability protection, offer some planning opportunities, and provide some legitimacy to your business endeavors. You may also benefit from electing to treat that LLC as an S-Corporation, but you should make sure you run the numbers and understand the commitments involved. The calculations are quite specific and nuanced, so it’s best to work with an experienced tax pro to get these numbers together for you.
You may save on payroll taxes, but your income tax due may be higher in the S-Corp. You’ll also need to have payroll software and legit bookkeeping than you can get away with if you’re not an S-Corp. You need to be ready to plan and pay for an additional tax return as well as work with a pro more often throughout the year.
If you’re ready for all that’s involved, an S-Corporation may be a good fit for you.
Luke Frye is the founder of Timber Tax, a tax filing service for creative professionals and small business owners. Got a question about tax filing? You can book a call with him here.