29. Understanding S Corp and LLC Taxes

In today's episode of Purposeful Profit, I'm helping answer one of the most common questions I get from business owners:  

"Should I be an S corp or an LLC?"

And the answer is, they really are not mutually exclusive. 

You can be an LLC as a legal form AND still elect S corp status. And doing so, can generate significant tax savings under the right circumstances. 

Join me for this week's episode of Purposeful Profit where I'm exploring LLC and S corp tax treatment and when an S corp makes sense (and why talking to your tax advisor is so important). 

You'll learn:

• The difference between LLC and s corp tax treatment
• When to consider an S corp election
• How and when to file for S corp election

Mentioned in this episode:

• S Corp Tax Calculator
• Ready to put more profit in your pocket? Book your financial health assessment to continue the conversation

Other resources:
Get your Simple Financials Bookkeeping template
Get Your 30 Days of Money Mindset Prompts

DISCLAIMER: The information in this podcast is for informational purposes only and does not constitute an accountant-client relationship. While we use reasonable efforts to furnish accurate and up-to-date information, we assume no liability or responsibility for any errors, omissions or regulatory updates.

Transcript

Welcome to Purposeful Profit, where I help you take your business to the next level. I'm Carla Moats, Finance and Strategy Coach, and Fractional CFO for high-achieving female entrepreneurs. I'm here to empower women to build wildly profitable businesses that give them the freedom to live their dream lives. I'll use my more than 30 years of finance and consulting experience to take the mystery out of your finances, help you make more money, and go after your next big thing.

Hi there and welcome back to the Purposeful Profit Podcast. I'm Carla Moats, I'm your host and I am a financial and accounting expert and a financial whisperer to female founders. My mission is to help you get your finances in order and put more profit in your pocket. And to that end today, we are going to talk about a question that comes up with a lot of my clients which is, “Should I be an S Corp?” 

To answer that question, you need to understand how LLC or sole proprietor taxation works and then how S Corp taxation works. And so today I'm going to walk you through that because an S Corp can generate savings and payroll taxes and to a lesser degree income taxes. Your savings really depend on a number of factors which I'm going to walk through today. 

In the show notes, I will be linking an S Corp tax calculator that you can use. You can see how the calculations that I'm talking about today were calculated and you can also use it to run your own scenarios.

But before we start, my little disclaimer for my attorneys, tax laws change frequently and can be complicated. By listening to this podcast, I hope to educate you to be a more informed business owner, but I'm not your tax advisor. This podcast should not be a substitute for personal tax advice. You need to seek out your own personal tax advice. So use the tax calculator, use the information I give you in this podcast to be able to ask questions of your tax advisor, to do some of your own research, but definitely go get personal tax advice.

In today's episode, you're going to learn the difference between LLC and S Corp tax treatment. You're also going to learn when to consider an S Corp election, and then you're also going to finally learn how and when to file for an S Corp election. So, let's dive in. 

First, let's just talk about it LLC versus an S Corp. An LLC is a legal entity that's governed by state statute. It is not a tax status and by that I mean you can't go out and find an LLC tax return.

Conversely, an S Corp is both a legal entity type and a tax status. It's also governed by state statute. But I can go out and find a tax return for an S Corp—it's called an 1120 S. It is both a legal entity type and a tax status. They are also both what we call in the accounting profession, “pass-through” entities. Meaning that the business itself is not paying the income taxes. So even though an S Corp files a tax return, the S Corp itself is not writing a check or making the payment for the taxes.  

C Corp, which is a different corporate entity type—corporation is its own separate entity and it does pay taxes. So both an S Corp and LLC are “passed-through” entities, which we're going to talk about more later. Another thing to know is kind of some history.

LLCs are relatively a new thing. They've only been around for about 30 years. The vast majority of states passed their LLC legislation in the mid to late 90s (and I'm going to date myself here). Back when I was in college in the late 80s and early 90s, and I was taking my individual corporate taxation classes as part of my accounting degree, LLCs didn't exist. We learned about the C Corp, S Corps, Partnerships, and LLCs really did not exist at the time or weren't taught. So, it's something that's “newer”.

LLCs are generally less expensive to form. They have fewer administration headaches but whether you need an LLC or an S Corp is a question for your attorney, not your accountant. Your account is here to advise you as to the tax impact. To make sure you're filing your taxes correctly, and you're taking advantage of whatever tax benefits you can get but,  “Do I need an LLC?” or “Do I need an official S Corp legal entity?” is really a question for your accountant.

One of the benefits of LLCs is that they give you the option of filing as an S Corp for taxes without actually being an S Corp as a legal entity. So things in an S Corp legal entity can require articles of incorporation and board meeting minutes. Generally speaking, if you're just filing your taxes as an S Corp, you're not going to have those.

Again, because it's a state-regulated entity, you do need to know what your state and local tax laws are. Generally speaking, an LLC is just much simpler. You're not going to have a lot of the administrative paperwork that you're going to have with an S Corp.

Before we talk about tax savings, we need to kind of set a baseline of knowledge and what I want to do is walk through the default LLC taxation. If you're somebody out there who's listening, and who does not yet have an LLC, this applies to you too. If you're a single-owner LLC, you're a sole proprietor, and if you don't have an LLC at all, you're also a sole proprietor.

So if you are a single-member LLC, your income and expenses flow through your personal return and they get filed on Schedule C of your 1040, you don't actually file a federal LLC return. You just have to gather up all of your reports from your accounting system or receipts. You report your total revenue and all your expenses on Schedule C of your 1040.

Now, some states may require state returns or require other taxes. So again, consult your local laws. If you're a multi-owner LLC, you have your partnership on this LLC with one or more other people, including a spouse, you get treated as a partnership and your LLC does file a federal 1065 partnership return, it's not an LLC return, it’s a partnership return. And that partnership return is also a “passed-through” entity. Your partnership will send you a K-1 for your share of revenue and expenses and you're going to file that on schedule E of your personal return.

Same basic idea, the income is still flowing through to your personal return, but as a sole proprietor, it's going on schedule C of your 1040, and if you have multiple owners it's going on schedule E of your personal return.

Now here's one of the key things I think a lot of you are aware of, which is the “real bite”. When people talk about LLC versus S Corp, you pay a self-employment tax of 15.3%. If you're an employee of a company, when you get your paycheck, they take out Social Security and Medicare and there are two parts to Social Security and Medicare. There's the employee portion, which is 7.65%, and there is the employer portion, which is 7.65%. Add these two numbers up together and you get 15.3% and as a sole proprietor, you are paying the full load. So you take your net income on your tax return and multiply it by 15.3% and that's the amount that you are paying in self-employment taxes.

Now, you do get to deduct half of that before you calculate your income taxes, which we're going to talk about, and which is built into the calculator. The idea here is that the IRS, while they're going to assess you the 15.3%, they're then going to let you deduct the employer portion. But your income from your LLC taxes is ordinary income and so whatever income you're passing through is going to get taxed at your ordinary tax rates. Let's take an example, and this is what's in the tax calculator.

Let's say you make $300K in revenue and you have $200K in expenses, so your net profit is $100K. A $100K is kind of a general threshold that I see a lot of tax pros using as a threshold for S Corp because we are going to talk about you going to incur some additional expenses in accounting and legal fees for an S Corp. So, a $100K seems to be kind of the sweet spot that a lot of tax pros want to look at it. I generally tell my clients when they get around $60 to $70,000 in profit to start talking to that tax pro because if it got $60 to $70,000 this year, often $100,000 in next year's not out of reach.

But again, you've got $300K in revenue, $200K in expenses, net profit of $100K. So your pay is $15,300 in self-employment taxes—that's the 15.3% times $100K. Then, you're going to deduct half of that as an adjustment to income. So you're going to pay income taxes on $92,350. So take the $100,000 minus the $7,650, which is half of the $15,300 and you get $92,350. That's what you're going to pay income taxes on.

Now let's just say your effective tax rate is 30%. That's going to yield you income taxes of $27,705. If you don't know what an effective tax rate is, that's just if you go to your tax return from last year and you take your total tax liability, not the amount you owe, but your total tax liability, and you divide it by your total income, that gives you an average or an effective tax rate. We're going to assume 30%. That means your total taxes as a sole proprietor LLC is $43,005. It's $15,300 and self-employment taxes and $27,705 in income taxes. Again, at the end of the show notes, go download the sales tax calculator and you can come back and listen to this episode again and you can follow the calculations through on the calculator. 

So let's talk about what changes when you are an S Corp. First an S Corp is going to file an 1120 S. Do not do this on your own. This is one of the reasons we say you should expect to pay higher accounting and tax fees because you're going to be paying for an 1120 S. You may also be paying for a higher quality tax person. I see a number of clients who up until this time have had their taxes done, but maybe their “Uncle Ed” or somebody they know who knew individual returns, and not everybody who knows individual returns is going to know S Corp. You want somebody who does a lot of work with S Corps because there's a lot of there's a lot of intricacy. Other things can come into play with an S Corp, other tax advantages you can get that we're not really going to go into today. So you're going to need a good quality tax advisor.

Another thing that comes into play is you have to pay yourself a reasonable salary if you have income. You need to plan for this cash flow. This is one of the key things that's important is not only do I have the profit, but I have the sustainable cash flow. Particularly, if I have inconsistent income where I have a $20K came on and then I have a couple of months with nothing, and then I have a $10K came on then, I have a $40K came on, you've got a plan for that reasonable salary—cash flow. Now you don't necessarily have to pay your salary bi-weekly or weekly. I even worked with somebody who cut themselves a check once a year, more often they cut themselves a check once a month and your tax advisor is also going to help you determine this amount. It's basically they can go out and look at similar-sized businesses, the market rate for somebody to run a business like yours, what would you have to pay somebody to do your job. It's a lot of different things they can look at. There is a rule out there (I should really call it a rule), it's a guideline that a lot of people will use, which is the 60-40 rule. It says you take 60% of your income via salary and 40% via distributions. This is not an officially accepted IRS  standard for a reasonable salary, but it is one the law of tax accountants will use, and it's one if you go out on the internet how to determine a reasonable salary, you'll find references to this.

Your business pays half the Social Security and Medicare and you pay half, but you're only paying it on your salary. That's one of the differences here, is you're going to pay the payroll taxes just on your salary. In the example I'm going to give you, you’re going to pay yourself a $60,000 salary. So, remember above you paid self-employment taxes on $100K. Now, you're going to pay him just on your salary which is $60,000 and this is a large part of what's driving your savings.

So, let's take this case above again. Only now we're going to pay ourselves a $60,000 salary and we had $300K in revenue again. But we're going to go ahead and add some expenses because we're going to have higher tax and accounting fees. So instead of $200K in expenses before any salary—we're going to say it's $210K. So we're going to $10K (and I'm just picking that number—it's a nice and even number). We're going to add $10K in additional expenses.

Now, profit before any salary is $90K, not $100K. So your business pays the employer share of Social Security and Medicare and they also have to pay federal unemployment. Now, your business may also be subject to state unemployment. The calculator does not take states into account but on $60K your Social Security, Medicare, and federal unemployment, this comes to $5,010 and your share of Social Security and Medicare is detected for your paycheck. So, that's $4,590 and that's just Social Security and Medicare.

The difference between the $4,590 and the $5,010 is that federal self-employment or federal unemployment. Employees don't pay unemployment, that's purely an employer expense. So, your total payroll taxes are $9,600. That's the $4,590 you paid and the $5,010 per year of the S Corp paid versus $15,300 is an LLC.

This is driven by the fact that you're paying payroll taxes on the salary and not on that entire $100,000 pass-through. Now, your escort gets to deduct your salary and the employer taxes his expenses. If we take $300K minus our $210K and expenses from before the salary, minus our $60K salary, minus our $55,010 in employer payroll taxes, we get $24,990. This is now what gets passed through on our tax return. So, we were passing through $100,000 above. Now, we're passing through $24,990 and we still have an effective tax rate of 30%.

The key thing here is you also have to pay tax on that $60K. You're getting a salary of $60K and you're going to pay taxes on that. When we calculate all that out, your total income taxes are $25,497 versus $27,705 in an LLC. Again a little bit of savings here, not a huge savings, but you are getting a little bit of savings on income taxes.

So, after I work all these numbers out, my total taxes that I paid as an LLC is $4,305. As an S Corp, I'm paying $35,097. That's a savings of almost $8,000. So, it's not small, it's a good amount of money. $6K, is coming from payroll tax savings and $2K is coming from income tax savings. So, I saved $8K and with that, I paid myself a salary of $60,000 and I added in $10,000 in incremental expenses that I'm incurring because I'm an S Corp.

Now one thing to know as you look at the calculator is the savings are going to vary based on a combination of your profit, your effective tax rate, and your salary. So, go download the sales tax calculator,  and follow my math, and then you can play with it in your own scenarios.

Do S Corps have drawbacks? They do have some drawbacks. So let's talk about those. They're more expensive to maintain and they may be subject to some additional state requirements. Don't just use this calculator to make a decision. Use it to kind of educate yourself on how the numbers stack out in different scenarios. But make sure you've done some due diligence, understood your state laws, and talked to a tax pro. You're going to need to process payroll. I highly recommend Gusto, even though I do my own bookkeeping in QBO and I do any bookkeeping clients I have in QBO. I do not use QBO’s payroll. I recommend Gusto, and you will need a tax advisor. Not all tax advisors can handle S Corps as I mentioned. I often will find that when you elect an S Corp, it's also a time at which often you'll see people changing bookkeepers and or tax advisors when they go to S Corp because there's also a little more accounting complexity. You want a bookkeeper who's done some work with S Corps, you want a tax advisor who's done some work with S Corps, and then you got to have the cash flow to handle that salary.

So after all this is said and done, what happens if I want to elect S Corp status? You're going to file R's form 2553 by March 15th for 2024. Everybody that's down here listening, I'm assuming it was in business on one-one, and so if you were in business on one-one in 2024, you would file it by March 15th of this year.

So this podcast is going live on March 7th. It gives you about a week, and I am going to link that form in the show notes. In conclusion, today, you know your S Corp can save you significant tax dollars, but you really do need to think it through. Expect to pay higher tax and accounting fees, and potentially some higher legal fees as well. Talk to your tax advisor, and then download the tax savings calculator. It is at www.carlamoats.com/scorpcalculator and then I invite you to book a consult call, book a Financial Health call at www.carlamoats.com/workwithme and we can continue the conversation. And thanks for being here and I will see you next week.

Thanks so much for listening to the show. Remember that your finances deserve some love. Finance doesn't have to be complicated or overwhelming, and you do not have to do it alone. I'd love to talk to you about your business, so please come on over to www.carlamoats.com to learn more. Or if you're ready for financial and strategy support that will uplevel all your business, go to www.carlamoats.com/workwithme to book your free financial assessment. And the last favor I'll ask is for you to help me get out the word. Tell your friends about this podcast and share it on your favorite social media. Until next week. Go create some purposeful profit.