Often, many of the technical terms that you’ll hear about taxes seem like confusing acronyms. Two of those terms could be LLC (Limited Liability Company) and S-Corp (S-Corporation). However, the S-Corp or LLC for independent contractor classification is important to understand when making educated decisions about your tax situation.
After reading this article, you’ll have a better understanding of what being an LLC or S-Corp means, including the differences and similarities. You’ll be able to make an informed decision about whether either of these options would be a good fit for your freelance business.
And yes, as an independent contractor the IRS automatically treats you as a business owner. Embrace it and enjoy the tax benefits!
Let’s dive in and clear the confusion about becoming an S-Corp or LLC for self-employed taxes.
An LLC is a business entity created at the state level that is organized to protect the business owner’s assets. The LLC does this by limiting liability. This means that the business owner will not be liable for any of the business’s debts or liabilities.
In other words, if you get sued by a client, you will not have to worry about paying for it out of your own pocket. Any legal liability is limited to the business’s assets. They are separate from one another.
In most situations, the answer here is no. An LLC most likely will not change your overall tax situation. A single-member LLC, which means that there is only one business owner, is treated as a disregarded entity for tax purposes.
That means that all of the business’s profits and losses will flow through to your personal tax return (Form 1040) in Schedule C. This is the exact same tax treatment as if you were a sole proprietor (i.e. you never formed an LLC).
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If you do have a business partner, you are effectively treated as an LLC taxed as a partnership, which means that you must file a different tax return called Form 1065, which is due on March 15th. Then, your business’s profits and losses pass through to each owner based upon the percentage of the business that they own.
If you’re looking to become an LLC for a tax break, unfortunately you won’t be receiving one.
However, forming an LLC could be a good decision to reduce liability and legitimize your business.
Unfortunately, there is no blanket answer here because forming an LLC happens at the state level. Each state has different formation requirements and fees, ranging from $50 to $500.
Annually, you’ll be required to certify your LLC by filing an Annual Report, which costs anywhere from $50 to $500 as well depending on your state.
Other than those standard costs, some states or municipalities require you to file business specific tax returns. However, these tax liabilities are normally very small. This is because the government does not want to discourage small businesses from forming LLCs. For example, Tennessee’s Franchise and Excise tax return is a minimum $100/year tax.
Unlike an LLC, an S-Corporation is not formed at the state level. Instead, it is a federal tax designation that corporations or LLCs can elect. Basically, what this means is that the S-Corp paperwork only happens at the federal level and all things remain the same at the state level
For example, if you are an LLC with Wyoming and file to be taxed as an S-Corp with the IRS, Wyoming still only views you as an LLC.
To form an S-Corporation, a qualifying corporation or LLC must file a form 2253 to the IRS. Keep in mind that this does not change anything at the state level.
For some, yes! The benefit of this tax designation is that it offers some of the benefits of a corporation without having to pay double taxation. Yes, you read that right -- double taxation. Which is why corporations (often called C-Corps) are often not a good idea for freelancers. However, the S-Corporation could definitely be a good idea.
As the owner (shareholder) of an S-Corp, you can save money on taxes because you elect to ONLY pay employer taxes (Social Security and Medicare) on the salary that you are paid, instead of your business’s entire net profit. In 2020, the combined Social Security and Medicare tax rate is 15.3% (employer and employee portion).
If you set your salary at $80,000 this year and your total freelance income (after expenses) is $100,000, you are making a $20,000 net profit.
In this situation, you would save $3,060 in taxes by becoming an S-Corporation. This is calculated by taking the combined Social Security and Medicare rate times your net profit (15.3% x $20,000).
However, you may be thinking: “Why can’t I just set my salary at $1,000 per year and save even more?!”.
Unfortunately, that is likely disallowed due to the IRS’s definition of reasonable compensation, which means that your salary must be appropriate for your role within your freelancing business, taking your expertise and responsibilities into consideration.
Subjective? Yes. However, the IRS has the final say here so err on the side of conservatism and pay yourself appropriately!
To elect to be taxed as an S-Corporation, first you must become an LLC or Corporation. See above for the costs of forming an LLC.
Filing the S-Corporation election form with the IRS is free. However, there are additional administrative requirements of being an LLC:
However, if you decide that the tax savings of becoming an S-Corporation are worth the additional administrative costs, it could be worth pursuing. Personally, I do not recommend adding additional complexity to your tax situation without working closely with a tax expert.
As an independent contractor, you are viewed as a business for tax purposes. Being a business owner, you have several choices as to how you’d like to structure your business entity.
Therefore, it’s important to be informed about your options and consistently evaluate your current reality. This will ensure that you are staying compliant while minimizing taxes along the way.
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