So your part-time hobby has turned into a business or a few favors for friends have turned into a fully-fledged income, but when it comes to paying taxes, you don’t know where to start. You know that you have to pay your taxes, but all of the legal jargon has you confused. Well while there are a multitude of choices as to how to establish your business, the easiest ones would be to file it as an S Corporation or LLC. While an S Corporation or LLC have many similarities, they also both have their advantages and disadvantages in taxes as noted below.
The beauty of LLC taxation is that you get to choose how you are taxed. If you are a single member LLC, by default you will pay taxes as a sole proprietor. This means that you will have to pay taxes on all business profit earned on your personal income tax form.
Multi-owners of a LLC are taxed as partnerships by default and must pay taxes on their distributed share of the profits. The profit share is agreed upon in the LLC operating agreement and each owner is responsible for only the taxes of their share. Even if the money is not distributed to them and is left in the business’s bank account, taxes on this money is still due.
LLCs can also be taxed as corporations by filing the IRS Form 8832, Entity Classification Election.
A LLC can also be taxed as an S Corporation by filing the IRS Form 2553
Election By a Small Business Corporation.
This is one of the main tax benefits of running a LLC, the flexibility of choosing your tax structure.
If you choose to be a sole proprietor, partnership or s corporation, you do not pay federal taxes on your business taxes. Rather, your income flows through to your personal tax return where you pay taxes. So the amount of taxes you pay depends on your individual tax rate. Moreover, you are taxed on all income regardless if you leave the income in your business bank account or not.
S Corporation Taxation
As a Corporation (S or C) you are expected to pay yourself a reasonable salary. Salaries and wages are subject to payroll taxes. Paying compensation to the owners is a very costly way of taking out money from the corporation. This is why a lot of s corporation owners try to take money through distributions. The IRS frowns upon this and reserves the right to re-classify your distributions as wages.
However when compared to the sole proprietorship, the s corporation is at an advantage. Owners of S Corporations are only liable for payroll taxes (self-employment tax) on the salary that they draw from their business profits. While sole proprietor pay self-employment taxes on all their income regardless of they choose to leave it in the business or not. This is the main tax benefit of filing your business as an S Corporation.
The IRS will examine your S Corporation more closely since there is a potential to abuse the tax benefits it provides. You have to withdraw a “reasonable” salary for yourself and your employees. For example, if your business makes millions per year but you only draw a $30,000 salary, questions will be raised.
Even though owners save on self-employment taxes, there are still other expenses to consider. Legal and accounting fees are generally higher for S Corporations. Also, some states impose additional fees on S Corporations, with California being one of them.
S Corporation or LLC
Overall, there are some pros and cons to weigh when considering the tax implications of either an S Corporation or LLC. You have to do your due diligence when researching and figure out the best solution for your business. Which tax structure best suits you depends on your individual circumstances. It is best you consult a CPA to explain the tax implications on your personal circumstances.