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:
- Similar fees and processes to set up and maintain
- Both serve as "pass through" businesses for income tax
- Both will help shield your personal assets from business liabilities
- Both will help keep business finances and expenses separate from personal
- 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
Happy Contracting!
Jim Roberts