Making the decision to start your own business is one that you’ll never forget. Once you’ve planted a seed for a new innovative product or service, how do you ensure your business blooms into a finished product? As you establish roots, some questions will, inevitably, arise about the legal process of setting up your business, such as how to classify it for tax purposes.
When tax season arrives, a business owner will need to understand the differences between S-Corp and LLC businesses. For your tax-purposes, let’s examine the differences.
What Is an S-Corp?
Contrary to what many business owners may think, an S-Corp is not a type of business entity. LLCs, corporations, partnerships, and sole proprietorships are all types of business entities. An S-Corp is simply a tax classification offered by the Internal Revenue Service. If you’re not familiar with the various tax classifications, it’s highly recommended you contact a business law specialist like wh Law before choosing the ideal route for your business venture.
What Is an LLC?
An LLC is a type of business entity that is known to separate its owners, known as members, from the entity. LLCs can have one or more members. While the specific definition of LLCs vary depending on the state that you’re currently operating in, they tend to offer more flexibility for management and financial reporting obligations than other types of business entities. In general starting an LLC is easier and cheaper than starting an s–corp in any US state.
Tax Classifications
The Internal Revenue Service uses four different business tax classifications for filings. These include the following:
- Sole Proprietorships
- Partnerships
- C-Corps
- S-Corps
It’s important to note that there is no LLC tax classification. Automatically, LLCs are taxed as sole proprietorships or partnerships, depending on the number of members the business has. However, LLC members can opt to have their business classified as a C-corp or S-corp for tax purposes. There are many different advantages that you can gain from pursuing this route.
The Difference in Earnings Reporting
When you’re taxed as a sole proprietorship or a partnership, you’re responsible for reporting all of the business income and your portion of that income on your personal tax returns. All of the income is counted as personal income and is taxed as such. You’ll be responsible for paying Social Security and Medicare taxes on all the income. Social security tax is around 12.4 percent, and the medicare tax is around 2.9 percent.
When it comes to an LLC, the earnings of the business are reported differently. An owner or member of the LLC must be given a reasonable salary from the business’s earnings. This salary will be reported on their tax return and as a business expense. The member will also need to report any remaining profit the business made on their tax return.
When it comes to paying Medicare and Social Security tax, the member will only be responsible for paying the respective percentages for the salary they reported. They don’t have to pay these two taxes on the remaining business profit they reported on their tax return.
Can Any Business Qualify as an S-Corp?
While many LLCs can qualify for S-corp status on their taxes, that isn’t always the case. There are some select exceptions where a business is not permitted to claim S-corp status. Exceptions to the rule include the following individuals/groups:
- Foreign LLC
- Nonresident immigrant member/owner
- LLC with 100+ Members
Any business that qualifies to file for S-corp status can do so regardless of how long they’ve been in business. You’ll simply need to fill out IRS Form 2553. This is called the Election By A Small Business Corporation. This document will need to be signed by all of your shareholders prior to submission.
Once accepted, the IRS will alert you via mail of your new S-corp tax filing status. You must receive verification of your status change before filing taxes under an S-corp with the Internal Revenue Service.
Is Changing to an S-Corp Worth It for You?
Every business owner’s situation is a little different from the next business owner’s. You’ll need to take into account certain data such as your annual business profits to determine whether or not this type of tax filing will benefit you as a business owner or not. As a first step, we suggest looking into your average annual profits.
While you may think that setting a very low salary is the key to avoiding taxation for Social Security and Medicare, but that’s not always the case. For the most part, the IRS will scrutinize the salaries that you report.
These designated salaries must be deemed reasonable when compared to other businesses in your industry. If your business currently profits more than what an average salary would be for your position, then filing for S-corp status could save you some money on your taxes. If your profits are about equal to a reasonable salary, then changing tax filing status won’t be too beneficial for the business owner.
Wrap-Up
Understanding the difference between an S-corp and an LLC can assist you in setting up your business in the most streamlined and cost-efficient way possible. Many business owners are disoriented early-on by technical jargon of tax-filing procedure and often don’t realize they’re not set-up in the right structure for them, financially speaking. Experts advise that you seek the assistance of a business attorney to determine what filing status is best for you and your business to avoid any unnecessary turbulence during tax season.
S-Corp and LLC words 3d lettering -DepositPhotos
