LLC or S-Corp?

Please head over to iselerfinancial.com/podcast to submit your question and I'll answer it on a future episode. A couple of weeks ago, I shared a bunch of info about self-employment tax. Here's a quick recap. Self-employment tax is the equivalent of fica, but for freelancers, sole proprietors, partners in partnerships and members of LLCs. All of those types of people have to pay self-employment tax. And that tax like FICA is used to pay into Social Security and Medicare.

One point I really leaned into in that episode was that self-employment tax is owed on your total net business profits regardless of whether you treat that money as compensation or not. That's true even if all of those profits live in a dedicated business bank account and never hit your personal account. It's all considered earned income. As a result, there's no way for those types of business owners to actually pay themselves a salary.

But at the end of that episode, I teased out an exception to the self-employment tax rules, which is called the S Corp election. I'll admit this is kind of a niche topic, alright? But it's important for anyone who runs their own business and wants to know if they're making the right decisions.

I find that lots of people wanna up their game, want to make their businesses more legit, but are totally confused about the differences among business structure options and what that choice means for both income and taxes. Today we're gonna focus on the differences between LLCs and S Corps. But let's start with a quick overview of sole proprietors and partnerships before diving into LLCs.

A sole proprietor is pretty much anyone who trades work for money but doesn't have a formal business structure. So that certainly includes freelancers, but it also includes lots of musicians, artists, writers, certainly lots of roadies, which is how I made my living for many years. And it even includes a kid in your neighborhood who rakes leaves for cash. Those are all sole proprietors.

There's absolutely no difference between the owner and the business when it comes to income, profits, or liability for sole proprietors. Business income is your income business liabilities are your liabilities. Partnerships are basically like sole proprietors, but they have more people. Partners share in both profits and losses, and there is no liability protection between the business and the owners or among different owners.

A limited liability company or LLC is organized and registered at the state level. It's pretty easy to do and typically costs a few hundred bucks a year to maintain. And what it does, as the name implies, is limit the liability between the company and the company owner. So for example, if somebody walks into your office and slips on a banana peel, they can sue the business, but your personal assets can be excluded from that lawsuit.

That's not the case if you're a sole proprietor or a partner in a partnership. that lawsuit might mean the end of your business, but you'll get to keep your house and your car and all your stuff. LLCs also protect members, which is what LLC owners are called from liability for and from other members.

One example is if a member in a multi-member LLC gets divorced, that person's slice of the business will get looped into the divorce process, but the other member's ownership and personal assets will not be at stake. Honestly, there are very few downsides to registering an LLC if you work for yourself. It doesn't cost all that much and if there's any possibility at all that you might get sued for any part of your work, you'll be glad that there's some separation between business and personal.

You don't have to have an LLC to work for yourself, of course. And there's situations where the odds of somebody suing you are so low that it just doesn't matter. Or for certain other vocations where you're required to have a lot of industry specific professional insurance just to operate, you might already have plenty of liability protection without registering an LLC.

But for everyone else who's self-employed, I think it's worth considering this as a move for limiting your personal risk exposure without a lot of extra hassle. But what an LLC does not do is change your tax status. Even though they offer lots of protection when it comes to legal and financial liability, lLCs offer no benefit when it comes to taxation. In fact, the IRS term for one member LLCs is disregarded entity. Kind of a harsh toke for all the one member LLCs, right?

But when it comes to taxes, the IRS does not care whether you register your business as an LLC. And that brings us to subchapter s Corporations also called S-Corps. While an LLC is a business organization, but not a tax status, an S corp is a tax status, but not a business organization. In other words, you must have already formed and registered your business before electing to be treated as an S-corp.

And an LLC can choose to be treated as an S corp for tax purposes by filling out and submitting IRS form 2 5 5 3. There are some rules that go along with that form and that filing. They're not super complicated, but I'm not gonna get into that here. So why would anyone elect to have their business treated as an S Corp? The main reason is that it allows you to treat yourself as an employee and therefore pay yourself a salary.

In other words, you can carve out a portion of your net profits and treat that as earned income, on which FICA is due, and the rest of the profits can flow through as ordinary income. Now, ordinary income is still subject to income tax, okay? You're not avoiding that with the S-Corp election. But it avoids that extra 15 ish percent that you have to pay on top of income tax in the form of employment tax. Here's the thing.

The IRS stipulates that with very few exceptions, an s corp owner called a shareholder must receive reasonable compensation unquote, but the IRS doesn't stipulate exactly what reasonable looks like for different industries or even across industries. What's reasonable compensation for being a musician or writing a book or making things that you sell on Etsy? It's different depending on your situation, and it's open to interpretation.

I. Now I have my own ideas about how much of your net profits should be considered reasonable compensation. But I'm a CFP and I'm not a CPA. A CPA is an expert in tax law and is authorized to represent you in tax court if you get audited. A CFP can't do that, nor is there such a thing as advisor client confidentiality for CFPs.

So if you're considering the S-corp election, you should 100% get your CPA to sign off on the process and help decide what qualifies as reasonable for you and your business before you get started. That said, here's a quick example using some back of the napkin kind of math. The calculation for self-employment tax is kind of complicated, but it works out to 14.13% of net profit while FICA works out to 15.3% of earned income.

Okay, so let's say that you have a one person business that generates a hundred K in net profits. If you are a sole proprietor freelancer, or one member LLC, that entire 100 K is subject to self-employment tax, and you'll owe about 14,130 in self-employment taxes. Now, let's say instead that you have a one member LLC and elect to be treated as an S corp. Let's also say that you and your CPA decide that 50,000 is a reasonable salary based on that a hundred K net profit.

You'll owe about 7,650 in FICA based on that salary with the remaining profits flowing through as ordinary income and avoiding fica. Remember, it's still subject to income tax, but it avoids that employment tax. So in the scenarios described above, you would save in the ballpark of 6,500 bucks in employment taxes by choosing the S-Corp election. Not bad, right? So why doesn't everyone do this? Well, the easy answer is that the S-Corp election is a lot more complicated.

When you have a one member LLC, you don't have to worry about running payroll because you can't actually treat yourself as an employee and so you avoid all kinds of paperwork. That's not true when your business is treated as an S-corp. You have to regularly run payroll, which means making payments to the IRS and your state for income tax and paying into fica. You can't just wait until the end of the year and see how it shakes out.

You have to do a lot more paperwork and be more proactive about accounting and paying taxes in real time. Another drawback of being treated as an S-corp is that you can no longer claim a bunch of business expenses on your personal tax return like you can if you're a freelancer, sole proprietor, partner in a partnership or member of an LLC.

That's not a huge deal because you can either have the business pay those expenses directly, or since you can now treat yourself as an employee, you can submit receipts to your business and get reimbursed the same way that any employee would. The point is, though, that you'll need to start thinking about bookkeeping differently and be more on top of things as they happen instead of waiting until next year when it's tax filing time to start adding up all of those write-offs.

And finally, one downside of treating only a portion of your business profits as compensation means that you are paying less into Social Security and Medicare, which means that you'll have lower benefits from those programs in retirement. That said, a great way to offset that risk is to take the money you save on taxes now and invest it for the future. Again, it's not super hard, but it is one more thing that you have to think about with an S corp.

So how do you know if the S corp election is a good idea for you? The most basic answer is pretty much when you're making more money than you need. So if your business generates just enough profits for you to get by, or maybe even a little bit less than that, then it probably isn't worth the extra effort and filing requirements to be treated as an S corp.

If I had to put a ballpark number on it, I'd say you could start having that conversation when your net business profits approach a hundred k. Again, this is just ballpark, there's no hard and fast rules about this, but below that, it just might be too much work relative to the benefits. Another reason you might want choose the S-corp election is to avoid surprises at tax filing time. This is honestly why I chose to do it that way for my business.

When I was still a roadie, I made more or less the same amount of money for several years in a row, but depending on how the bands I worked for treated compensation, I might get a big refund one year or owe a bunch of money the next year. It was so hard for me to anticipate that in advance, and I hated that uncertainty. So I chose the S-Corp election when I launched Iseler Financial, even though at that time there was no profit at all. Okay, so that's probably enough for now on LLCs and S Corps.

I know that it's kind of complicated, but I also know that so many of the people I talk to and work with want to understand this better and don't really know where to start. So hopefully, after listening to that, you at least understand the basics when it comes to LLCs and S-Corp and know what kinds of conversations you should be having next.

If you have a question about business structure, feel free to drop me a line at iselerfinancial.com/podcast, or you can sign up for weekly office hours by going to my homepage, iselerfinancial.com and scrolling down to the section that says, have a quick question. I'll add both of those links in the show notes. Okay. Next week I'll be back with a conversation with Adam Turla from the Band murder By Death.

I recorded that band's first record way back in 2002 and really enjoyed catching up with Adam. Now it's time for disclosures. The Thing We Never Talk About is for educational and entertainment purposes only. It's not legal, investment or tax advice, but you knew that already, right? People on the show, including the host, may have interests for or against any investments discussed. So do yourself a favor and don't make any decisions based on what you hear on this or any podcast.

If you have a money or finance question you'd like answered in a future episode, please visit iselerfinancial.com/podcast. And of course Iseler is spelled I-S-E-L-E-R. And if you like what you hear, please like and subscribe to this show wherever you get your podcasts. And you can get my insights on money and more delivered directly to your inbox by subscribing to my Keep It Easy newsletter at iselerfinancial.com/newsletter. Thanks for listening. I appreciate you.