LLC vs. S Corporation Taxation for Digital Entrepreneurs: Which Minimizes Self-Employment Tax Legally
Two years ago while working from home, I received a tax bill I couldn’t believe! I was so excited about having my best year as a freelancer, a big percentage of my earnings went to the IRS because the IRS classified me as an LLC and thus all of my profits were being taxed as self employment taxes. At that moment I realized not only did I owe the IRS for income taxes on my income, but I also owed the IRS because I employed myself and was responsible for self employment taxes unless I electioned S Corporation status.
The Problem: Most Digital entrepreneurs will fault to LLC as their tax treatment and pay thousands of dollars more than needed, than if they would have used an S Corporation, because all of their profits will be taxed as self employment tax.
The Drawbacks: You need to consider if the tax savings outweigh the payroll costs to support running paychecks, filing payroll taxes are examples of support to operate, payroll could be considered an ongoing expense because you will have added the reasonable salary rules as a limitation on how much you will pay yourself, in addition, some of the deductions you may be entitled may also be taken away.
The Solution: When you elect S Corporation as your tax treatement, you will separate your money between reasonable salary (which will be taxed through payroll tax) and distributons (meaning you will not pay self employment taxes on distributions) and in turn, will be able to withhold your hard work legally!
Prerequisites and Context
You must have a registered LLC with your state, a dedicated business checking account, and must understand what your net income will be annually at a minimum of $60,000-$80,000 per year to take into account the loss of potential net savings for administrative costs may exceed potential tax saving benefits through operating as an S Corporation.
Understanding the Tax Landscape for Digital Entrepreneurs
The Core Problem: Self-Employment Tax vs. Corporate Structure
The IRS considers you to be a “disregarded entity” if you operate a regular LLC; all of your net income is assessed a self-employment tax of 15.3% (FICA/Social Security/Medicare) no matter if you take that money out of the business or leave it in the business. The IRS will assess you tax on the total profit.
Defining the Default LLC Tax Treatment
As an LLC is considered a pass-through entity, you would report your income on Schedule C of your individual tax return. It’s easy to do, but it can get expensive since you will pay income tax plus 15.3% self-employment tax on every dollar generated in profit.
The S Corporation Pivot: How It Changes Your Tax Liability
S Corp is not a way to classify a type of business entity but is the tax classification of your business. When you file for S Corp election, you will become an employee of your company. You will have to pay yourself a reasonable salary and you will only pay taxes on the distributions that remain after paying you a salary. The amount that you receive as a distribution will not be subject to the 15.3% self-employment tax and therein lies the magic!
LLC vs S Corp for online business tax savings.
Analyzing the Self-Employment Tax Reduction Strategies
The goal is to keep the amount that is subject to payroll tax as low as possible while being able to comply with IRS guidelines for your business. In this example, using an LLC and assuming a net profit of $150,000, the self-employment tax will apply to the full $150,000.Understanding the Tax Savings of Paying Yourself a Salary
When you are owner leased as an S Corp, you can pay yourself a $70,000 salary and only pay self-employment taxes on that amount. The difference of $80,000 will be taxed as distributions (dividends). Through this method S Corporations can save thousands of dollars in payroll taxes.
Step 3:
The Role of Reasonable Compensation Requirements
You cannot simply just pay yourself $1, and take the rest of your profit as a dividend. The IRS requires that you pay yourself reasonable wages for the work you provide. For example, if you are a web designer, you should look up how much other web designers in your area are paid and base your wage on that amount. Paying yourself too little could result in the IRS recategorizing your dividends into wages and charging you retroactive taxes and penalties.
Paying Yourself Reasonable Wages for an S Corp
Tax Breakdown Comparison (Example)
- Standard LLC: $150,000—> 15.3% = $22,950 in self-employment taxes owed.
- S Corp: $70,000—> 15.3% = $10,710 in self-employment taxes owed.
- Total Tax savings: $12,240.
Navigating the QBI Deduction and Payroll Obligations
Understanding the QBI Deduction Phase-out Thresholds
Many small businesses qualify for the QBI deduction and can deduct 20% of qualified business income. As a business grows so can their profits, therefore, the QBI will phase out based on the business type and profit level. Ensure your S Corp salary do not push you into the thresholds that lose these benefits.
Managing Payroll Tax Obligations and Employer Responsibilities
As an S corporation, you are now considered an employer.To be in compliance with S Corporation regulations, you must withhold employee wages, remit employer payroll taxes, and submit quarterly payroll reports. In order to comply with all local, state, and federal tax laws, you will need a payroll service provider such as Gusto or ADP because manually handling this process will lead to many costly mistakes.
Strategic Execution: Form 2553 and Election Timing
Determining the Optimal S Corp Election Timing
You usually have until March 15th of your tax year to file for your S Corporation election to be effective for that year. After this date, you will either have to wait until the next year or seek late election relief, both of which create added headaches.
Filing Form 2553: A Step-by-Step Compliance Checklist
- Obtain an Employer Identification Number: You need an EIN to file Form 2553.
- Complete Form 2553: Fill out the company’s name and the effective date of the S election.
- Obtain Shareholder Consent: All shareholders (owners) of the company must sign Form 2553.
- Send Form 2553 via Mail or Fax: Send completed Form 2553 to the IRS Service Center for your company.
- Pay Attention to the “Effective Date” Field: This will determine the date your company will change from a corporation (C Corp) to an S Corporation.
The Hidden Cost: State Franchise Tax and Compliance Burdens
Why State Franchise Tax Differences Matter for Digital Nomads
There are significant differences in the franchise taxes between California S Corporations and California standard LLCs.Be certain to review your state’s individual tax regulations prior to switching. You may find federal tax relief when switching to an S Corporation is offset by your state’s franchise taxes due on an annual basis.
Evaluating Administrative Overhead vs. Potential Tax Savings
An S Corporation adds extra documentation to your business. You will need to create a separate payroll system, file the corporate tax return (Form 1120-S), and possibly pay for professional help with bookkeeping. If switching will save you $2,000 in federal taxes but your bookkeeping cost has gone up $1,500, is it really worth it?
What Didn’t Work For Me
I attempted to do my own payroll using a simple spreadsheet and missed my quarterly filing deadline by 3 days. I then received a penalty that reduced half of my tax savings for that quarter. Lesson Learned: Don’t try to do your payroll yourself. Go with a reputable company that will guarantee their filings for you. In addition, I initially paid myself too low in order to maximize my tax savings; I was concerned about the IRS auditing me and losing sleep. I finally increased my salary to a “market rate”.
Edge Case: The “Reasonable Compensation” Safe Harbor Strategy
There is no specific number associated with “reasonable compensation”; however, if you maintain good records you can create a “safe harbor” for the IRS. This would include saving job postings for jobs similar to the one in which your company operates. If the IRS challenges your compensation, you will have documentation to support the amount you paid yourself.
Frequently Asked Questions
Can I retroactively change my LLC to an S Corp for the previous tax year?
For the most part, you can’t file a Form 2553 retroactively. You must file your Form 2553 by the due date to elect to be a S Corporation. Although the IRS will waive the requirement for late election relief under some circumstances, it isn’t guaranteed and you’ll probably need a tax professional to file your late election relief request.
How does the QBI deduction interact with my S Corp salary?
Your S Corporation salary is a business expense and will reduce your net profit; therefore, the higher your salary, the lower your QBI deduction.
What happens if the IRS determines my salary is not “reasonable”?
In this case, they will convert part of your drawing account to salary. You will then owe unpaid payroll taxes (with interest and penalty). This is an expensive mistake and can be avoided by paying yourself what the marketplace determines is the appropriate salary for your trade.
