What is an LLC vs. S-Corp: Which is right for your small business?

What is an LLC versus an S Corp and why in the world can no one explain it in layman's terms? We are gonna get really technical in this video. So technical that I'm gonna have to refer to my notes because I can even misexplain this. Misexplain? Is that a word? It's gonna be a word now. I can mess this up if I don't actually explain it properly. 

There are a lot of things you need to understand, to know which one is right for you. It took me years to understand this and cost me tens of thousands of dollars, because I didn't understand it. So although I am by no means your tax lawyer or any sort of tax expert, let me explain this in a way that will actually make sense so that you can understand for yourself, which is better for your business - an LLC or an S Corp.

I'm Tara Wagner, breakthrough coach and lifelong entrepreneur. I help other entrepreneurs use a holistic approach to business so they can create profits they can depend on without burning themselves out. If that sounds like your jam, be sure to check out my free training on how you can do the same.

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All right, before we jump in, there are two caveats that you must understand. 

• Number one, always talk to your CPA or a tax attorney when it comes to this stuff, because your business is unique and what you learn on a YouTube video can be educational and it can be helpful, but only to get you to understand what you need to understand so that when you go into those meetings with your professionals, you sound a little bit more intelligent. That's really all it's about, but you must talk to somebody who can look at the details of your business and really help you decide, which is right for you, an LLC or an S Corp. 
• Caveat number two, is that talking about an LLC versus an S Corp is really apples to oranges because they are really different things. So let me describe what an LLC is, what an S Corp is. and then through that, show you how you can determine which one is best for you. 
• And also let me add an extra caveat of saying that this applies to people in the US with small businesses. So if you're not in the US, this is probably not gonna make much sense for you, and you definitely need to learn what the different options are for you in your country. 

What is an LLC?

First of all, what is an LLC? LLC stands for limited liability company. This is a legal or business structure that just protects you and your personal assets. Which basically means if your business is sued or you lose everything and go bankrupt, nobody can come after your house, or your personal car, or your personal savings. It separates you from your business. 

LLCs by themselves do not save you money on your taxes. A lot of people will say that and they're completely misunderstanding what an LLC is. It can't save you money on your taxes because it's not a tax classification. It's a business structure. A business structure just says this is how I'm setting up my business. 

A tax classification tells the IRS how to tax that business, but there are four different types of tax classifications that your LLC can have. 

1. You can be set up as a sole proprietor 
2. A partnership
3. An S Corp 
4. A C Corp 

S Corp is the one that we're gonna talk about in just a second. 

Now, by default, the tax classification for an LLC is set up as sole proprietor, unless you set it up otherwise. What this means is that on your taxes, all of your income, all of your business expenses get reported on your personal tax return. And you're gonna pay your federal, your state, and your self-employment taxes out of that personal tax return as well. You're not gonna pay Medicare or social security taxes. 

Who should have an LLC?

Now who should have an LLC? 

1. Number one in any business that has a higher likelihood of being sued. If you've got a lot of liability in your business, it's good to set up an LLC because it limits the liability to the business so that people, again, can't come after your personal assets if you go bankrupt, or if you get sued. 
2. If you don't run a high risk business, you might still consider an LLC when you're making enough money for the costs of your LLC to be covered by your profits. So in other words, there's gonna be a cost for setup. There's gonna be yearly fees associated with it, usually from your state. Mine are from my state, I'm assuming it's all states. You might also have CPA fees for additional forms that have to be filled out when you're doing your tax returns. 

So when should you set up an LLC, depending on your business, this might be from day one, or it might be when you've got a couple extra thousand dollars in profit to be able to handle any extra fees associated with running an LLC. 

Okay. So that is an LLC. If that does not make sense, let me know in the comments and I will do my best to answer your questions, but just know again, I'm not an expert. Get educated, but definitely go and talk to your CPA or your tax attorney. 

What is an S Corp?

What is an S Corp though? First of all, you need to understand that you can have an LLC without an S Corp, but to obtain S Corp status. You first gotta have your LLC.

Quick interjection as we're editing here, I misspoke. You can have an S Corp without an LLC. What I should have said is you have to have some sort of business entity. So you might be a sole proprietor instead of an LLC. So just know that as I'm explaining all of this, that's what I actually mean. Your S Corp will have to have some sort of business entity, whether that is an LLC or something else. 

And then you get to decide, does my tax classification make more sense as a sole proprietor, a partnership, an S Corp, or a C Corp? We're specifically gonna talk about S Corp here.

An S Corp also known as an S corporation, also known as an S subchapter is a tax classification that you can put your LLC into. There are some limitations as to who can have an S Corp, but most small business owners easily meet those requirements. And the tax benefits usually can be really beneficial. So it is a popular choice. Okay? So this is where things start to get a little bit more technical and I'm gonna stick to my notes so that I describe it really well. 

The first thing to understand about the difference between an LLC and an S Corp is how you actually take your profits from the business. An LLC owner takes distributions only. Distributions are basically just your profits you're getting paid from the LLC or from the business. S Corp owners are called shareholders now. So now you're a shareholder instead of just a business owner, you take the same amount of money, or you can take the same amount of money. That's totally up to you, but you're gonna break it into two categories. Okay, you're gonna take some of that money as an employee now of the business. So you're gonna take it as a salary, and you're gonna take some of it as distributions, just like you did as a LLC owner, because you're doing this, this changes the way that you pay tax, which can decrease your taxes in some cases, but not all of them. We'll get to that in just a second. 

So an LLC is gonna pay income tax and self-employment tax on the entire profit that they take while an S Corp is gonna pay income tax on the entire amount but self-employment tax only on your salary. 

How S Corp Decreases Taxes

What this is doing is limiting the double taxation that small business owners can incur. The same dollar gets taxed twice once when the company is holding it. And once when it makes it into your personal bank account. 

So let me give you an example, and I found this example online, let's say you make a hundred thousand dollars as profit, money that you get to keep from the business after your expenses. 

A 100K as an LLC means that you're gonna pay self-employment tax, which is currently at 15.3% on the full 100K plus you're gonna pay a personal income tax of 24%, right? So you are paying that tax twice on the same amount of money. 

With an S Corp you might take the same 100K but now you're gonna take a salary of 60K and you're gonna take a distribution of 40K, same hundred split into those two categories. You're gonna pay that personal income tax now on that 100K, but you're gonna pay your self-employment tax, that 15.3% only on the 60K plus you're gonna pay some payroll taxes that you weren't paying before as an LLC.

Given these numbers, your tax liability as an LLC would be about $39,000 and as an S Corp would be about $33,000. So even though you're paying more in, in terms of payroll taxes, overall, your tax burden is decreased. 

To give you another example, the first year I moved my LLC to an S Corp. My tax bill went from 17,000 to 7,000, simply because I wasn't being double taxed anymore. 

I was way overdue on setting up an S Corp, by the way, you might not save that same amount of money the first time you do it, it's gonna depend on how much profit you're already making. So if you've delayed moving to an S Corp for too long, you've been getting double taxed up to this point, and you're gonna save a lot of money. If not, what you're gonna do is prevent the loss of a lot of money instead. The reason I waited so long though, is because I was told like everybody else, an LLC saves you money on your taxes. No, an LLC by itself does not an LLC with an S Corp set up and paid for will. So definitely make sure that you understand which is which and which one's right for you, which by the way, let's talk about that. 

Drawbacks of an S Corp

Let's talk about the drawbacks of an S Corp so that you can understand what's right for you. 

1. So number one drawback of an S Corp is that not all states will recognize an S Corp status. So you really need to make sure you're doing your homework here to make sure that this will even make sense for you.
2. The second drawback of an S Corp is that you now have to pay yourself on payroll, which just complicates the process of paying yourself especially if you're a solopreneur, who's gotten away with not having to do payroll. You're just doing distributions. You're taking cash. You're taking profit from the business. You don't have to worry about anything else, but with payroll, it gets complicated. You gotta pay all kinds of payroll taxes. You got all kinds of quarterly things happening. You gotta make sure you send yourself a W2 or W9, which one is I can never remember. You can tell, I do not do my own payroll. This is an added expense. And it's also an added headache for some business owners. So you need to take that into account as well. 
3. The third drawback of an S Corp is that you cannot set up an S Corp unless you are making enough to pay yourself what is called a reasonable salary. Talk about a vague tax code. A reasonable salary basically just means the IRS is not gonna dictate how much you pay yourself, but you do have to be able to justify it. So if you wanna try to decrease your tax bill by paying yourself $10 a year, you're not gonna be able to justify that. But if you were to get audited and say to the IRS, you know, I'm paying myself this much because this is how much it would cost if I were to hire somebody or, you know, this is whatever the justification is, you gotta be able to justify it. And so you gotta really think for yourself, what is a reasonable salary based on my profit, based on what I do in the business, based on how many hours I work and all of those things, if you can justify it, then it would be considered a reasonable salary. But if you cannot pay yourself enough yet you're not making enough profit to take a reasonable salary. Then it does not make sense to have an S Corp because nine times out of 10, you're gonna pay more to have the S Corp than you're gonna save in taxes. 

I do have a rough ballpark number of how much profit you might wanna be making that is based on what a CPA told me and my business. So do keep that in mind, but I will get into that in just a second. 

1. The fourth drawback of an S Corp, you are gonna have much more complicated taxes, meaning you're probably not gonna DIY it unless you're really good at taxes. And this usually means that you're gonna pay more to be able to get your taxes done. We pay roughly about $1500 to $1800 right now with one S Corp. My husband just set up his second S Corp. So we're expecting that bill to go up some more. This only makes sense for us because although we're paying more in the short term with payroll fees, with payroll taxes, with CPA, with all of those things, we're gonna save on the back end because our overall tax bill is gonna be lower. 

When to move to an S Corp?

So knowing all of this, when should you consider moving to an S Corp? Again, number one, make sure you talk to your CPA or a tax lawyer about your specific unique business, but here are some things to consider. 

• First of all, if your company has profit left over after you pay yourself a reasonable salary. So figure out what that reasonable salary is, right? Let's say you're gonna pay yourself $50,000 a year. If you've got money left over after that 50,000, it might be time to switch over. This usually happens between $50,000 to $70,000 again, depending. So this is again where you gotta talk to that CPA to really make sure, but at least you have a rough ballpark. 
• Another consideration, if you are reinvesting your profits back into growth right now, it might actually benefit you to stay a sole proprietor for a little bit longer, because you're gonna be writing those investments off, which means you're not gonna have a lot of distributions, which means you're paying fees for an S Corp that you're not fully utilizing. You're not getting the tax benefit because you're not taking those profits, you're reinvesting it back into the business. 

So hopefully all of this clears up some of it for you, so that now you feel a little bit more educated and can make some phone calls to that CPA or that tax lawyer to make sure that you get everything set up the way it needs to be set up. 

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WHAT ABOUT YOU, BOSS?

What is better for your small business? An LLC or an S Corp?

Leave me a comment below.