Business Structures


So you've decided to create a company, now you need to decide how you will structure it. There are many different types of business structures, but for independent contractors and most small single-owner businesses, there are only two that matter:  LLCs and S-Corps. Many aspects of these two structures are similar. For example:
  1. Similar fees and processes to set up and maintain
  2. Both serve as "pass through" businesses for income tax
  3. Both will help shield your personal assets from business liabilities
  4. Both will help keep business finances and expenses separate from personal
  5. Both will add legitimacy to your venture

The primary differences between LLCs and S-Corps revolve around taxes:  How much you pay, how you pay, and how often you pay. Let's start with the simpler of the two, LLCs.

LLC Overview
If you are the only owner of your LLC (which is a safe assumption if you are an independent contractor), then the IRS by default will classify you as a "disregarded entity." This is a word that you will see often when filling out forms and filing taxes, and all it means is that the IRS doesn't consider your business separate from you for tax purposes. It is "disregarded." That means income from your LLC will be reported on your personal tax return as opposed to a business return.


Business related income and expenses get documented on a separate form called "Schedule C, Profit or Loss from Business (Sole Proprietorship)." (add link) This form helps you calculate your net profit from business activity, and then that amount "passes through" to your personal taxes on Form 1040 (add link).

That sounds pretty easy, right? Well, the income from your business will be treated as self-employment income, which comes with a couple of additional considerations.

First, income tax in the US is designed as a "pay as you go" system. Think about the taxes taken out of your paycheck when you work as an employee. Working for yourself does not absolve you of this responsibility, and the IRS will expect regular quarterly tax payments throughout the year. You calculate the amount owed and submit payment using Form 1040-ES, Estimated Tax for Individuals.

Second, you should be aware that some of the taxes you will pay on income from your LLC will appear higher than the taxes you pay as an employee. You have probably seen on paystubs that employees pay a 6.2% Social Security tax and a 1.45% Medicare tax (2017 rates), but many people don't realize that the EMPLOYER is also making matching payments on behalf of the employee. As a self-employed tax payor, you are responsible for paying both halves of these taxes. There are a couple of caveats though:  The "employer half" of the tax is considered a deductible expense, and the more expensive Social Security tax is only assessed on the first $127,200 of income. See the "SE Tax" page for a more detailed breakdown.

(I specifically said that taxes "appear" higher because I'm a firm believer that any and all expenses a company pays on your behalf are really being paid by you! Even if you don't realize it!)

S-Corp Overview
Unlike an LLC, an S-Corp is not considered a disregarded entity. This means the IRS recognize your business as a separate entity, and as a result you will be responsible for completing a business tax return (in this case, Form 1120S, U.S. Income Tax Return for an S corporation). However, your S-Corp will not be responsible for paying business taxes. Instead, and similar to an LLC, business profits will "pass through" to you, and you will report them on your personal tax return. However, and this is the real kicker, these profits will be reported as S-Corp distributions and NOT self-employment income. This means that you will be able to avoid paying self-employment taxes on the distributions passed through from your business.

That's a huge saving, right? Why wouldn't everyone just create an S-Corp instead of an LLC? Well, as always, there are a couple of important caveats and considerations to be aware of.

First, an S-Corp can't pass all business income through to the owner as a distribution. The S-Corp must pay the owner a "reasonable wage" as an employee of the S-Corp before any distributions can be made. As an example, if your S-Corp has $100,000 in income, but you pay yourself a reasonable wage of $50,000, then you are only saving self-employment tax on the other $50,000. You can see that as your reasonable wage increases the value of saved SE taxes decreases. See my post on "Reasonable Wages."

Second, some states charge a "Replacement Tax" on S-corps that will partially offset savings. In Illinois, for example, you will be responsible for paying 1.5% of your net profits (minus wages) back to the state.

Finally, the administrative costs (in terms of time and money) will be much higher with an S-Corp. The wages you pay yourself will require additional tax reporting, the S-Corp will need to submit a separate business tax return (due March 15, and it will be more difficult to reimburse yourself for personal costs associated with your business (think home office). In general, you will be responsible for more frequent and more complicated tax filing and more documentation.

Final Thoughts
If an S-Corp sounds too complicated to start, but you are interested in eventually squeezing out every last benefit of 1099 contracting, then I have a third option for you. You can start with an LLC, and then at some later point, file a form with the IRS and elect to have your LLC treated as an S-Corp! See my post on the topic here.

Happy Contracting!

Jim Roberts