Thanks to our friends at Collective for sponsoring this blog! Author: Andi Smiles
As a freelance designer, you’ve probably come across the terms LLC and S Corp, but deciding between the two can be overwhelming. There’s a lot to know when it comes to comparing the two and choosing the right one can make a big difference in the success of your freelance design career. In this guide, we’ll break down the differences between LLCs and S Corps, and help you determine which structure may be best for your business.
LLC and S Corp Basics
A Limited Liability Company (LLC) is a legal structure for your business. One of the main advantages of forming an LLC is that it offers limited liability protection. This means that your personal assets, such as your home or car, are, in most cases, protected if your business faces legal or financial issues.
Additionally, LLCs offer pass-through taxation – business profits are taxed at the personal level, not the business level, avoiding double taxation which is typical in a C Corp structure.
An S Corporation (or S Corp for short) is not a legal structure, but rather a tax election for your legal structure. This means that when you “are an S Corp”, you maintain your underlying legal structure (like an LLC) and are taxed under the rules of an S Corp. It’s important to know that to elect S Corp taxation, you must have an LLC or other legal structure already in place.
While we often refer to LLCs and S Corps as being two distinct choices for your business, in practice, they work together. A more accurate way to describe LLC vs S Corp is LLC taxed as an S Corp vs LLC with the default taxation. That’s a mouthful, which is why we shorten it to LLC vs S Corp.
Tax Implications of LLC and S Corp
The key difference between an LLC and S Corp is how you’re taxed. Both are pass-through tax structures, meaning business profits flow directly to the owner’s tax return and are taxed at the personal level. Beyond that, there are some differences.
How an LLC is taxed
An LLC is automatically taxed as a sole proprietorship and you pay two types of taxes on your business profits:
- Self-employment tax: 15.3% and is made up of Social Security and Medicare taxes
- Income tax: Varies based on your tax bracket
Remember, an LLC is a pass-through tax structure, so you won’t pay taxes at the business level. Instead, you report your business income on your personal tax return and pay taxes at the individual level.
How an S Corp is taxed
When your LLC is taxed as an S Corp, you don’t pay self-employment tax on your business profits. This is different from the default tax structure of an LLC, where business profits are subject to self-employment taxes.
As an S Corp, you only pay income tax on your profits, which pass through to your personal tax return. Here’s how it all works.
You, the owner, will become an employee of your business and are required to pay yourself a reasonable compensation through payroll. Like any other employee/employer relationship, your payroll earnings will be subject to payroll taxes, which are 15.3% and are made up of Social Security and Medicare taxes (yes, just like self-employment tax). Your business pays half of those taxes through employer payroll taxes and you pay the other half, which is deducted from your paycheck.
Now here’s where the potential tax savings come in: You only pay Social Security and Medicare taxes (that 15.3%) on your payrolled salary, not your business profit. We’ll break that down more in a moment, but before we do, here are a few additional things to keep in mind:
- Your payroll taxes and owner salary are tax deductible, reducing taxable profits
- There’s no set standard for setting a reasonable salary, it’s based on different factors. We go deeper into how to set your reasonable salary here.
- Federal and state income tax will be deducted from your paycheck, covering employee wages
- You still need to pay quarterly taxes on any expected pass-through S Corp profits
Tax Savings Comparison
Let’s compare taxes paid by a freelancer as both an LLC and an S Corp to demonstrate how S Corp tax savings could work.
That’s a $11,934 difference! In this example, with less of the total earnings subject to Social Security and Medicare taxes, you pay less taxes overall.
Keep in mind that these tax numbers don’t include your income taxes, which will vary based on your tax situation. Also, this is a simplified example for illustrative purposes. If you want a personalized comparison, check out Collective’s tax savings estimator.
Additional S Corp Considerations
It’s tempting to see the tax savings comparison and want to go all in on an S Corp tax election for your LLC, but operating an S Corp comes with additional costs and responsibilities.
Payroll Service Fees
Managing manual payroll can be a headache with various calculations, tax obligations, forms, and deadlines. Mistakes can lead to penalties and interest payments. You can save yourself the trouble by using a reliable payroll service tailored for S Corps, but these come with a cost.
Bookkeeping Costs
With S Corp taxation, you introduce more bookkeeping complexity into your business and you’ll need to invest in digital bookkeeping software or outsource to a bookkeeper.
Tax Preparation Fees
Unlike an LLC that only files one federal tax return, when you elect to be taxed as an S Corp you’ll need to file two tax returns. Your S Corp will file a corporate return called the 1120-S and you’ll file your personal tax return. Expect additional fees to file your S Corp’s tax return.
Which one is right for you?
An S Corp may not be right for everyone and the less you earn, the less beneficial an S Corp may be for your taxes. Even if you have some tax savings, the additional costs could offset your tax savings, leaving you with more tax complexity without the tax benefits.
While the IRS allows businesses at any stage to elect S Corp tax treatment, at Collective we’ve found that if you’re earning less than $60,000 in annual self-employment profit, then an S Corp may not be right for you yet. You can still set up an LLC and enjoy the limited liability benefits but may want to wait until you hit the $60,000 profit threshold before changing how your LLC is taxed.
If you earn more than $60,000 in annual self-employment profit, then it may be time to consider S Corp taxation for your LLC.
Collective Simplifies S Corps
At Collective, we specialize in S Corps for solopreneurs. Our all-in-one platform makes it easy to set up and maintain your S Corp, offering formation, bookkeeping, payroll, business tax returns, and compliance support all in one place. With your very own finance team of seasoned professionals, we give you the tools, technology, and team you need to power your business, all under one login. Learn more and sign up with Collective here.
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