LLCs and S-Corps: Your Top Entrepreneurial Questions, Answered
Building and creating drives you as an entrepreneur, business owner, or founder. That search for bringing something out of nothing is an addictive and honorable pursuit that often requires substantial amounts of hard work, dedication, and sacrifice.
But it can also be overwhelming, especially when you need all the answers. And while many entrepreneurs are willing to take on a "bootstrap" attitude to figure it out, some questions need to be answered to move forward.
And one of the most significant areas that bring anxiety and uncertainty to entrepreneurs is money and finances. Many questions need answers, from finding the right financing strategy for your business to understanding and managing taxes.
Eric Maldonado - owner and founder at Aquila Wealth Advisors - recently hosted an educational webinar to cover some of the most commonly-asked questions about money and finances in the entrepreneurial journey.
As part of our series on the top questions entrepreneurs ask, we've broken down the key considerations you should know when determining what business structure is suitable for your company.
What Are The Most Common Structures For Entrepreneurs?
The two most popular business structures for entrepreneurs and business owners are LLCs (Limited Liability Companies) and S-Corps.
Each filing has benefits, including tax savings, management costs, and liability mitigation. But it's essential to understand the differences between the two to decide which filing is right for your business.
LLC
LLCs are popular for entrepreneurs because they offer flexibility and protection from personal liability. An LLC must register with the state; setting up an LLC is relatively straightforward. You can consult a business attorney to help execute entity selection and creation. You can also choose how your business will be taxed - as a sole proprietorship (or "disregarded entity") or as a separate entity via an S-corp election.
S-Corp
S-Corps require more paperwork and formalities than LLCs but can offer tax savings depending on business profits. Many companies opt for an S-Corp filing because of the pass-through taxation your business will receive.
Some entrepreneurs also opt to set up an LLC first and, later, elect to be taxed as an S-Corp as the business revenue grows.
Other Less-Common Filings
In addition to LLCs and S-Corps, there are other filings that entrepreneurs may find helpful for their businesses.
These include C-Corps (corporations) and partnerships. Many new business owners begin as sole proprietorships. Still, they will often transition to either an LLC or an S-Corp.
What Are The Benefits Of An LLC vs. An S-Corp?
An LLC offers asset protection, pass-through taxation, and fewer formalities than an S-Corp. Conversely, setting up an S-Corp requires more paperwork and filing a separate tax return. You must comply with specific rules to maintain it. However, an S-Corp can offer tax savings by paying yourself a W-2 salary and a quarterly profit distribution.
How Does An LLC Affect Your Taxes?
Eventually, every entrepreneur needs to consider which legal entity is suitable for their business - such as an LLC or S-Corp. Within the US, this is usually done on the state level and affects how your taxes are filed and paid. Many entrepreneurs wonder if filing as an LLC will impact their taxes.
Here's the reality - filing as an LLC doesn't impact how much you pay in taxes. The primary benefit is that legal issues, such as a lawsuit or breach of contract, protect your personal assets from your business dealings.
Owners of an LLC are operating as a disregarded entity or sole proprietor by default, meaning that whatever comes into the business (minus expenses) goes toward your personal 1040 tax form. There's no payroll if you, as the owner, are the only employee. Instead, you'll pay total self-employment taxes on all net profits.
How Do You Choose Between an S-Corp and LLC?
Choosing between an LLC and S-Corp depends on a few factors - such as how much profit you expect to earn this year, how much tax savings can be made by setting up an S-corp, and how much time you or money you can spend managing the entity and keep things organized.
An LLC is often best for smaller businesses in the start-up stage.
Setting up and operating is more straightforward, requiring less paperwork and the taxes report on your personal income tax return (1040).
An S-Corp is an excellent choice as you grow and can pay yourself a reasonable salary and take quarterly profit distributions from the business. It's more complicated to set up and requires more paperwork. Still, it protects against personal liability and allows you to avoid double taxation, which a C-corporation requires.
Technically, you can operate as both an LLC and S-Corp. You'll need to file two tax returns with the IRS - one personal and another for the S-Corp. However, this can be beneficial if you want to tax some of your income as dividend distribution and not as self-employment income.
Your W2 becomes your annual salary, and you can continue taking owner draws from your LLC, which avoids payroll taxes like social security and Medicare.
What Is a "Reasonable Salary" In An S-Corp?
As an S-Corp, you must pay yourself as an employee of the business. A reasonable salary is commensurate with your work and wages of similar positions in your industry or region.
The IRS monitors S-Corp salaries to ensure they comply with regulations, so it's important to set yours at a rate that accurately reflects the value of your services for the business. It would help to document your business duties in your S-Corp's books and financial records.
Understanding your reasonable salary may help you determine whether or not an S-Corp is the right choice for your business. It's crucial to weigh the costs and benefits of operating as an LLC or S-Corp before deciding. Speak with a qualified advisor to help you choose the structure that works best for you.
What Is A Direct Distribution Without Payroll?
Another common question when looking at LLC vs. S-Corp is whether or not an S-Corp can directly distribute business money to the owner without processing it through payroll. The answer to this question is yes, but do it strategically.
Here's a helpful way to think about it. As an S-Corp, you can set up five different business bank checking or savings accounts:
● Revenue
● Operation Expenses (costs to run your business)
● Payroll (Your W2 within your operating expenses)
● Profit (quarterly owner's reward)
● Taxes
These profits can be distributed to the business owner without processing them through payroll, typically on a quarterly cadence. Transferring funds from your business "Profit" bank savings account to your "personal" bank account is known as an owner distribution or an owner draw.
You can directly distribute funds to yourself as the business owner from the profit account without running it through payroll. Still, recording it as an owner draw in your bookkeeping software would be best. The quarterly draw will not be subject to FICA payroll tax.
Think of it similarly to a quarterly dividend from shares you own in a publicly traded company. You don't pay the Social Security and Medicare taxes on the dividend income or capital gains. Still, you pay federal and state taxes depending on the dividend income or capital gains amounts.
How To Make The Right Choice for Your Entrepreneurial Pursuits
Ultimately, it's all about making the right choice for your business. Do your research, and be sure to consult with a qualified advisor before you make any decisions.
The LLC vs. S-Corp decision is worth addressing, as these structures will impact your business and personal taxes differently. Be sure to weigh the pros and cons of each before you make a decision.
If you want to learn more, contact us at Aquila Wealth Advisors to discuss your needs and get the advice you need to help you make the right choice for your business. I have years of experience working with entrepreneurs and am here to help with any questions. We can walk through your unique circumstances and look at your best options. With my help, you can make an informed decision that's right for your business.
Click here to set up a conversation, and let's get started! I look forward to helping you reach your goals!
