Choosing the right business structure is a foundational decision that impacts the trajectory of your business. As a financial planning firm working with service-based businesses and solo entrepreneurs, we know this decision can feel overwhelming. Your choice affects taxes, liability, compliance requirements, and even how you scale your business. Here, we’ll break down two of the most popular business structures: LLCs and S-Corps. By the end, you’ll have a clearer understanding of which structure suits your goals and how proper tax planning can save you money.
1. Limited Liability Company (LLC): Simplicity and Flexibility
The Limited Liability Company (LLC) is one of the most popular business structures for small business owners. It combines the liability protection of a corporation with the tax flexibility of a sole proprietorship or partnership.
Key Features:
Liability Protection: Owners (members) are generally not personally liable for the debts or liabilities of the business.
Tax Flexibility: An LLC is considered a pass-through entity by default. This means profits and losses pass through to the owners' personal tax returns, avoiding double taxation.
Management Flexibility: Members can manage the business themselves or hire managers.
Minimal Compliance: Compared to corporations, LLCs have fewer compliance requirements.
When to Choose an LLC:
Solo Entrepreneurs or Small Teams: Ideal if you want liability protection with minimal administrative burden.
Businesses Prioritizing Tax Flexibility: If you’re not ready to deal with payroll and corporate taxes but still want liability protection, an LLC offers simplicity.
Uncertain Growth Plans: An LLC can later elect S-Corp tax treatment, offering room for growth and strategic tax planning.
Potential Drawbacks:
Self-employment taxes: LLC owners may owe self-employment tax on all profits, which can add up.
Perception: Larger businesses or investors may view LLCs as less formal than corporations.
2. S-Corporation (S-Corp): Tax Savings and Structure
An S-Corporation isn’t a business entity itself but a tax designation available to eligible LLCs or corporations. It’s a popular choice for small businesses looking to reduce self-employment taxes.
Key Features:
Pass-Through Taxation: Like an LLC, an S-Corp avoids double taxation. However, you can save on self-employment taxes by designating a reasonable salary for the owner and treating the remaining profit as distributions (not subject to payroll taxes).
Liability Protection: Shareholders are protected from personal liability for business debts.
Formal Requirements: Includes maintaining corporate bylaws, holding regular meetings, and filing detailed paperwork.
When to Choose an S-Corp:
Service-Based Businesses with Profits: If your business generates consistent profits beyond what you need as a salary, an S-Corp can provide significant tax savings.
Small Teams: S-Corps are well-suited for businesses with a few owners or employees.
Tax Planning Goals: If you’re ready to set up payroll and track distributions, an S-Corp can minimize your overall tax burden.
Potential Drawbacks:
Administrative Burden: Requires detailed bookkeeping, corporate minutes, and adherence to strict IRS guidelines.
Reasonable Compensation Rule: The IRS scrutinizes S-Corp owners’ salaries to ensure they’re not disproportionately low to evade payroll taxes.
Real-Life Tax Comparison: LLC vs. S-Corp
To illustrate the tax implications of pass-through taxation (LLC) versus S-Corp taxation, let’s consider an example:
Scenario:
A solo entrepreneur earns $150,000 in net business income.
The entrepreneur operates either as an LLC or elects S-Corp taxation.
The S-Corp owner designates $80,000 as a reasonable salary and the remaining $70,000 as distributions.
Tax Breakdown:
LLC (Pass-Through Taxation):
Entire $150,000 is subject to self-employment tax (15.3% for Social Security and Medicare).
Self-employment tax: $150,000 x 15.3% = $22,950.
Income tax: Calculated on $150,000 (federal and state rates apply).
QBI deduction: Assuming eligibility, 20% of $150,000 = $30,000 deduction.
Taxable income after QBI: $150,000 - $30,000 = $120,000.
Total fed tax (assuming filing single & standard deduction) = $18,340
Total self-employment and income tax liability: Higher than S-Corp due to full exposure to self-employment tax.
S-Corp (Salary and Distributions):
Salary: $80,000 is subject to payroll taxes (15.3%).
Payroll taxes: $80,000 x 15.3% = $12,240 (shared by employer and employee).
Distributions: $70,000 is not subject to payroll taxes.
Total self-employment taxes: $12,240.
Income tax: Calculated on $150,000 (salary + distributions).
QBI deduction: Assuming eligibility, 20% of $70,000 (distributions only) = $14,000 deduction.
Taxable income after QBI: $150,000 - $14,000 = $136,000.
Total fed tax (assuming filing single & standard deduction) = $22,180
Savings:
By electing S-Corp taxation, the entrepreneur saves approximately $10,710 in self-employment taxes ($22,950 - $12,240) but pays approximately $3,840 more in federal taxes ($22,180 - $18,340) which would yield to a net saving of $6,870. These savings can be reinvested into the business or personal financial goals.
Tax Planning Considerations
For service-based businesses and solo entrepreneurs, tax efficiency is a major concern. Here are some key points to keep in mind:
Self-Employment Taxes: LLCs are subject to self-employment taxes on all profits. S-Corps can reduce this burden by splitting income between salary and distributions.
Reasonable Compensation: S-Corp owners must set a reasonable salary to avoid IRS scrutiny. The salary should align with industry standards for similar roles.
State Taxes: Some states impose additional fees or restrictions on LLCs and S-Corps. For example, California has an $800 annual LLC tax and additional fees based on gross receipts.
QBI Deduction: Proper planning is critical to ensure eligibility for the 20% QBI deduction, particularly for high-earning service-based businesses.
How to Decide
Selecting the right structure depends on your business’s current needs and future goals. Here’s how to approach the decision:
Step 1: Assess Your Priorities
Are you looking for simplicity? Start with an LLC.
Do you want to save on self-employment taxes? Consider an S-Corp.
Are you planning to scale and attract investors? An LLC taxed as an S-Corp offers flexibility without significant upfront complexity.
Step 2: Understand Your Financial Projections
Work with your financial planner to project revenues, expenses, and profits. This will clarify whether the tax savings of an S-Corp justify the added administrative requirements.
Step 3: Consult Your Advisors
Collaborate with your financial planner, tax advisor, and attorney. Each professional brings a unique perspective to ensure your decision aligns with legal, tax, and strategic considerations.
Future-Proofing Your Decision
One of the advantages of starting with an LLC is its flexibility. You can later elect to be taxed as an S-Corp as your business evolves. This ensures your business structure can adapt to your changing needs.
For example:
A solo consultant may start as an LLC for simplicity.
As the business grows and profits increase, they may elect S-Corp taxation to save on self-employment taxes.
With careful planning, the structure can accommodate more complex financial and operational goals.
Conclusion
Choosing the right business structure—LLC or S-Corp—is a critical decision that sets the foundation for your business’s success. For service-based businesses and solo entrepreneurs, understanding the trade-offs between liability protection, tax implications, and administrative complexity is key.
At AG Wealth Management, we specialize in financial planning for small business owners and advanced tax planning strategies tailored to help you save money, streamline operations, and achieve long-term financial stability. Whether you’re just starting out or looking to restructure your business, we’ll help you choose a path that aligns with your goals and reduces your tax burden.
Ready to take the next step? Contact AG Wealth Management today for a personalized consultation. Let’s work together to build a solid foundation for your business and financial future.