21 Oct S Corp vs LLC vs Sole Proprietorship: What are the tax limitations?
Are you a small business owner who feels intimidated and nervous that you are not saving enough to pay for future tax obligations? It is scary: the thought of terrible terms like “tax evasion,” “penalties,” and “audit.” I totally get that! Even though I myself am not a CPA, I would like to help you understand how your business is taxed by the federal government. Let’s talk about paying taxes for S Corp vs LLC vs Sole Proprietorship, and the limitations of each.
I honestly believe – and perhaps this is because I am not a CPA – that this might be useful for you. I find it helpful to break down the tax laws into the simplest terms possible. That way I can understand how our small business clients at Reconciled Solutions are affected. In this article, I will explain (in “layman’s terms”!) the concept of paying taxes on your business for:
- A single-member LLC/sole proprietorship
- An S Corp pass-through entity
Similarities between an S-Corp and a single-member LLC/sole proprietorship
First, there is one main similaritiy between these two entity types. The business owner will pay taxes on the net income of the business. Net Income equals Total Revenue less Cost of Goods Sold less Operational Expenses. This means that at the end of the day, whatever is left of your revenue after you pay out production expenses and your support staff is a taxable event.
There are a few key factors that differentiate the taxation of a single-member LLC/sole proprietor from an S Corp, including:
Number of tax returns in an LLC/sole proprietorship vs. S Corp
With an LLC/sole proprietorship, you will file one tax return as a part of your personal tax return: Form 1040. Your business’s performance will be recorded on a Schedule C. This is an additional schedule that is added to your 1040 tax return. A Schedule C filer typically does not include a Balance Sheet in their tax calculation.
In an S Corp, there will be two tax returns: one for the business and one for your personal taxes. So if you are hiring a tax preparer, you will be paying them twice. Once for the business return (which is due on March 15th) and once for the personal return (which is due on April 15th).
Self Employment Taxes
A shareholder in an S Corp will receive a form K-1 from the tax preparer. This K-1 represents the net income/loss of your business that “passes through” to your personal tax return, meaning that as an S Corp owner, the business itself will not pay taxes on the income of the business, but rather, the net income of the business will add to your personal tax burden, and you will pay taxes on your personal income tax return. This is the reason you hear people refer to an S Corp as a “pass-through entity”.
In an LLC/sole proprietorship, you will be paying taxes called Self Employment Taxes. This means that as the owner, you are paying the taxes of both the employER and the employEE of that business, since it is one and the same. That current rate is 15.3%, but it may be increasing. Right now, it is 7.65% on behalf of the employER and 7.65% on behalf of the employEE. The Single Member LLC owner is both employer and employee.
Payroll Expenses and Owner’s Pay
In an S Corp, the owner can be considered a part of payroll expenses. They can be paid a payroll throughout the course of the year, with payroll taxes subtracted from the business’s gross income. This is an expense to your business, and the payroll taxes paid will contribute toward the total tax liability for you as an individual.
In an LLC/sole proprietorship, we usually record the money the owner pays themselves on the balance sheet. We do not record that money on the profit and loss report. This means at first glance, it may look like an LLC is much more profitable than an S Corp with the same total revenue and expenses. In actuality, this is because the LLC does not include the Owner’s Pay on the Profit and Loss Report while the payroll wages paid to the owner of an S Corp will show on the Profit and Loss for the company.
In an S Corp, the owner will likely be paid via steady payroll deductions on the Profit and Loss. If they take any additional cash out of the business, we record this on the Balance Sheet as a Shareholder/Owner Distribution account. The owner would typically not be paying taxes against any Shareholder/Owners Distributions that happen throughout the course of the year. Instead, the owner takes this money without tax implication at the time of withdrawal.
In an LLC/Sole-proprietorship, the owner only takes distributions throughout the course of the year and would not have paid payroll taxes against those distributions at any point. They may choose to make Estimated Quarterly Tax Payments, but it would not be calculated on the exact dollar amount of Distributions; rather, it is calculated based on an estimate.
LLC/Sole Proprietorship vs. S Corp Setup
Now let’s take a look at a side-by-side comparison. This shows how things would differ for the same company set up as an LLC/Sole Proprietor vs. an S Corp.
LLC / Sole Proprietorship |
S Corp |
|
| Total Revenue | $500,000 | $500,000 |
| <Less Cost of Goods Sold> | <$150,000> | <$150,000> |
| Equals Gross Profit | $350,000 | $350,000 |
| <Less Operating Expenses> | <$120,000> | <$120,000> |
| <Less Owner’s Payroll Wages> | *<$0> | **<$175,000> |
| Equals Net Income (Taxable) |
$230,000 * Owner’s Pay is not listed on the Profit & Loss, so we do not know how much of this was distributed to the owner through the year. |
$55,000 **The Taxable Net Income is much lower in this scenario, but the owner would have paid payroll taxes throughout the year on the $175,000. |
I hope this information is useful to you and that federal taxation makes a little more sense than it did previously. Feel free to pepper me, your non-CPA business advisor, with questions!
We have a wonderful handout for you to refer to, which you can download here: Choose the Correct Business Entity.
Watch your inbox for next month’s newsletter where I will continue to explain, in simple terms, these often–confusing tax concepts!
