Let’s start by clearing up some common misconceptions. If you're a new business owner, you don’t actually need an LLC or an S corp. And you don't have to choose just one or the other.
The two can — and often do — work together to save small business owners money on their taxes. But they’re not right for every self-employed person.
Read on to learn about what exactly LLCs and S corps do, how they affect your taxes, and whether either is right for your freelance business.
LLCs vs. S corps: Key similarities and differences
LLCs and S corporations are two common ways for small business owners to separate themselves from their businesses. Ultimately, though, they’re pretty different. The LLC is a type of legal business structure, while the S corp is a tax classification.
In other words, LLCs have more to do with legal status, while S corps have more to do with your taxes. Because they fall into different categories, it’s possible for the same business to be both an LLC and an S corp. More on this later!
Before we dive into all the details, here’s a quick reference point on what each classification offers.
Now, let’s take a deeper dive into how LLCs and S corps work.
What is an LLC?
An LLC (short for "limited liability company") is a way to legally structure a business so that the owner’s personal assets are protected from business liabilities, like debts or lawsuits.
With an LLC, if you get sued by a client, only your business’s assets will be on the line — not your personal assets. (Assets include things like your LLC’s bank accounts, company car, and business real estate.)
This is because an LLC creates a distinction between the business owner — you — and your business. (With a sole proprietorship, on the other hand, there’s no such separation.)
LLCs can get taxed in all kinds of ways — including as an S corp. (More on this later!)
How to become an LLC as an independent contractor
LLCs are formed at the state level, and each state has its requirements. Typically, you’ll fill out a document called an “Article of Organization” or “Certificate of Organization” and submit it to your department of state.
Here’s an example of what California’s Article of Organization looks like.
The IRS isn’t informed or involved in this process at all. It won’t even care if you have an LLC — unless you elect to file taxes as an S corporation (more on this later!) or you have a business partner who isn’t family.
How much does it cost to form an LLC?
Depending on your state, registering as an LLC can cost anywhere from $40 to $500. You’ll have to pay this when you submit your Article of Organization.
You’ll have to certify your LLC every year or two by filing a report, called a “Statement of Information.” This can cost another $50 to $500, depending on your state. (Here’s an example of California’s Statement of Information!)
What is an S corp?
An S corp — short for “S corporation” — is a federal tax designation that allows a business owner to be taxed as an employee of their own business. I’ll explain why that’s helpful in a minute!
How S corps and LLC are connected
As mentioned, an LLC can elect to file its taxes as an S corp. The two aren’t mutually exclusive. In fact, a business can only elect an S corp after they’ve first registered as an LLC or other qualifying corporation. You can’t simply go from sole proprietor to S corp.
Remember: S corp taxation happens at the federal level, while LLCs are registered with your state. Choosing S corp taxation won’t affect anything there. For example, if you have an LLC in Wyoming and file to be taxed as an S corp with the IRS, Wyoming will still view you as an LLC.
How to register an S corp as an independent contractor
If you’re already an LLC (or other qualifying corporation), you can register to form an S corp by submitting Form 2553 with the IRS.
When should you register your S corp?
If you want the election to apply to the current year, file the form by March 15th.
If you miss the deadline, is it too late to file as an S corp?
Nope! It’s very common for this election to be made late. So common that the IRS even has instructions on how to get late-filing relief.
As long as you follow the instructions and offer an explanation for why it’s late — such as your bookkeeper forgetting to file the paperwork — it will likely be accepted.
How much does it cost to form an S corp?
Filing the S corp election form with the IRS is free.
However, on top of LLC certification costs, at the minimum, an S corp should be prepared to pay for:
- Payroll software or services
- Accounting services
- Bookkeeping services
In addition, adding complexity to your taxes generally comes with additional costs.
What other complications come with an S corp?
Here are a few other complexities to watch out for.
Filing separate business taxes
Unlike single-member LLCs, a business owner who has made an S election has to file a separate business tax return.
This return is called an 1120-S, and it’s a more complicated than a Schedule C.
Added audit risk
S corps come with some audit risk. So getting this return wrong can mean more of a headache. In most cases, it’s worth hiring an accountant to handle things for you.
Paying yourself a salary
Once you have an S corp, you’ll have to be paid as an employee of your business. And if you’re in a partnership, or there’s more than one owner, they’ll all need to be paid salaries as well. That means filing payroll returns throughout the year, like 941s, 940s, and W-2s.
With these extra complications, why would an independent contractor decide to file their taxes as an S corp? Depending on your business’ profits, there can be potential tax benefits.
We’ll explain how in a moment. First, here’s a roundup of how these two classifications compare.
How do LLC vs. S corp taxes work for independent contractors?
One big reason freelancers consider forming an LLC or an S corp? They’re looking for ways to lower their taxes. But is that how it works?
The short answer:
- Becoming an LLC generally won’t affect your taxes
- Forming an S corp can save you money on your taxes, if your income is high enough
Here’s a quick comparison of LLC vs. S corp taxes work:
Now, let’s break this down.
How LLC taxes work
In general, forming an LLC doesn’t provide you with any kind of automatic tax advantage.
How does one get taxed? It depends on how many LLC owners there are.
Taxes for single-member LLCs
When a sole proprietor forms an LLC on their own, that’s known as a “single-member” LLC. And a single-member LLC file taxes the same way a sole proprietor — on their personal 1040 return. The taxes they pay include:
- Self-employment taxes (Social Security and Medicare)
- Income taxes (state and federal)
Why does it work like that? The IRS views any single-member LLC as a “disregarded entity” when it comes to taxes. This means that the business isn’t separate from its owner for income tax purposes. Instead, all the profits are reported on the owner’s personal tax return (Form 1040).
From a tax perspective, there’s really no difference between a sole proprietorship and a single-member LLC. LLCs still get 1099s, and they have the exact same tax status as sole proprietorships by default.
Bottom line: If you’re looking for a tax break, you won’t find it here. That said, freelancers who form an LLC can still lower their tax bills tracking eligible business expenses and writing them off on their taxes. (Keep in mind, though, that you don’t need an LLC to write off these expenses.)
The Keeper app is one way to make expense tracking easy — and you might uncover eligible write-offs you didn’t know you had! The app automatically scan all your purchases for write-offs you can claim. It will even go through previous statements to find any expenses you might have missed.
At the end of the year, you’ll have a spreadsheet with all of your write-offs, ready to be entered into your Schedule C. Or you can file your taxes right in the app!
Taxes for LLCs with two members
If you have a business partner and you form an LLC together, you’re known as a “partnership.”
With a partnership, you’ll file a tax return called Form 1065 instead of the sole proprietor’s usual Schedule C. This is due on March 15th.
Form 1065 is where you’ll report your partnership’s profits and losses. These are then passed through to each owner’s personal tax return — on a Form K-1 — based on the percentage of the business they own.
The actual tax is calculated on your 1040 tax return.
How S corp taxes work
One of the main reasons independent contractors elect S corp taxation is the potential savings.
An S corp allows you to break down your self-employment earnings into two parts:
- Owner salary: Subject to both income and self-employment taxes (but deductible for the business)
- Net business earnings: 100% subject to income taxes, but not subject to self-employment taxes
Here’s how taxes on the two parts of your earnings break down.
Taxes on your salary
If your business is profitable enough to pay yourself, you’re required to treat some of those payments as wages.
You’ll pay FICA (self-employment) taxes and income taxes on these wages.
This is the only part of your income you’ll have to pay self-employment taxes on — which makes it tempting to pay yourself as small a salary as possible.
Of course, the IRS won’t allow an “unreasonably” low salary. More on that later!
Taxes on your distributions
Once an S corp has paid out its salaries and business expenses, the leftover profits are passed through to the owner’s personal tax return.
These profits are known as “distributions.” (If there are multiple owners, the distributions are divided based on what percentage of the company each person owns.)
You don’t pay self-employment tax on S corp distributions — you only pay income tax. And here’s where those potential tax savings come in.
If the business earns enough to pay the owner a reasonable salary and have something left over to pass on in the form of distributions, they’ll end up saving money on taxes. Because the distribution part of those earnings get shielded from self-employment tax.
What is a reasonable salary for S corp owners?
The IRS requires all S corporation owners who take money out of their business to pay themselves “reasonable compensation.”
However, they stay intentionally vague on what “reasonable” means, because every situation is different. For instance, first-year business owners often struggle to make a profit. So looking at similar jobs in their field won’t paint the most accurate picture of what’s reasonable.
How the IRS thinks about reasonable salaries
Here are some factors the IRS will consider:
- How much you’ve taken out of your business this year and in previous years
- How much income your business made after subtracting work expenses
- What services your business performed
- How much other people in your field, with your responsibilities, tend to earn
What happens if the IRS thinks your salary isn’t reasonable?
The IRS has been known to reclassify owner distributions as salary in cases where it felt the taxpayer was abusing the election.
Usually this happens in cases if the taxpayer took large tax-free distributions while paying themselves a very small salary. In those cases, the business owner was on the hook for back taxes and steep payroll penalties.
Before you rush out to form an S corp, remember that it won’t always save you money on your taxes. It depends on how much your business is earning.
S corp taxes in action
Let’s look at an example of a self-employed person who made the S corp election.
Eric owns a one-man tutoring business. After subtracting his business write-offs for the year, he’s got $30,000 in leftover profit. (However, his actual business bank account is much lower, because he already spent that money paying for his rent and other living expenses.)
Most private tutors in Eric’s area earn about $50,000 a year. But because his business is new, he simply can’t afford to pay himself that much. After using Keeper’s tax calculator, Eric realizes that he only has enough funds to cover payroll taxes on about $20,000 of wages.
He issues a W-2 for himself for $20,000 and pays taxes on it. The remaining $10,000 of profit is still reported on his tax return. He’ll have to pay income taxes on it — but not self-employment taxes.
Because self-employment tax is a flat 15.3%, that’s $1,530 he didn’t have to pay the IRS ($10,000 x 0.153 = $1,530).
Was S corp election worth it for Eric? That depends on how much money he spent on costs like his LLC formation fees and payroll expenses — plus how much time he spent dealing with the paperwork. At the end of the day, all that might well outweigh the $1,530 he saved.
How’s how to figure out if an S corp the right choice for you.
When should you form an LLC or S corp as a 1099 worker?
While each situation is different, there are a few common characteristics of a business well-suited to form an LLC and choose S corp taxation.
Let’s get into them, so you can make the right choice.
Who should consider forming an LLC?
Not all 1099 workers decide to form an LLC. If you’re starting a new business or side hustle or are picking up a few hours of weekly gig work, then staying a sole proprietor is probably the simplest option for you.
Here are a few reasons forming an LLC might be a good idea:
- ✓ You want to protect your personal assets but don’t want to deal with as much regulation as a corporation
- ✓ You’re working in an industry higher liability risk, like selling cannabis or operating a hair salon
- ✓ You have the money needed to register a business entity and pay all the other associated costs
- ✓ You might want to be taxed as an S corp down the line
Who should consider forming an S corp?
If your business profits are greater than what would be considered a reasonable salary for your work, then you might want to form an S corp to save money on your taxes.
A reasonable salary will differ from job to job. But we generally recommend waiting to consider electing an S corp until your taxable income — meaning, your net profit — is at least $80,000.
Once you reached that threshold, you typically have enough to pay for the necessities, including:
- A salary for yourself
- LLC formation fees
- Admin expenses like payroll software
And after that, you’ll still have profit left over that can be distributed to you as the owner. That means S corp taxation can be a viable option for you. Before $80,000, though, it’s often not worth the hassle to form an S corp.
Adding complexity to your business structure or taxes is a big decision. Hopefully, this article is a helpful jumping-off point for you as you decide whether it’s time to pursue LLC or S corp status.
And don’t forget that Keeper is here to help you do more than track tax write-offs! If you want more advice regarding LLCs vs S corps for 1099 workers, reach out to us at email@example.com.
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