LLC vs S CORPORATION Tax Benefits, Savings & Implications on Taxation
In this video we discuss the main differences between an LLC and an S Corporation. We provide graphs to show the tax benefits of an LLC and the tax benefits of an S Corp. We also show you how you can save on taxes when having and LLC and the tax savings of an S Corp.
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One of the most common questions that we get here at Freedom Tax Accounting is what’s better for my business, an LLC, or an S CORP. In this video, we’re going to discuss the LLC tax structures, the S Corporation tax structures. And we’re also going to go into this because of the tax benefits of the LLC, and the tax benefits of the S Corporation. So that’s what we’re going to talk about in this video.
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Now, many entrepreneurs that are going to start a business or that they already have a business form. They read all this stuff on the internet about LLCs and S Corporations. And one of the most common questions we get here at Freedom Tax is “What’s better for my business, an LLC or an S CORP?” Well, every case is different. The information that we’re going to share with you today is general knowledge. But every case is different. That’s why we always recommend that you consult with a tax professional, so that they can evaluate your case and they can make a recommendation based on your specific business needs. If you are in need of a consultation, you can contact us in Freedom Tax accounting, because we do provide those types of consultations.
Now, let’s get into the content. So basically, the first thing you need to do or know about an LLC and an S CORP is what are they? What is an LLC and what is an S CORP. And here is a list of the four main legal business structures. There are many different types of legal business structures in the USA, but these are the four most common. Now, these are legal business structures. You have your sole proprietorship, basically this is where the independent contractors, self-employed people, they work as a sole proprietorship, legally, you have a partnership, you have a limited liability company, which is the LLC, and you have the Corporation.
Now as you can see, the S Corporation is not on this list. Why? Because the S Corporation is not a legal business structure. An S Corporation is a tax structure that is applied to a business and we will go deeper into that a little bit further on this video. So that’s important to know. The LLC yes is a legal business structure. But the S Corporation is not a legal business structure. The S Corporation is only a tax structure for a business.
Okay, now, let’s go first into the LLC tax structure. When you have an LLC, and you have an LLC with one owner, okay, the IRS gives that LLC an automatic designation for taxes. The IRS says this single member LLC legally is a sole proprietorship and he needs to file these taxes on their Schedule C or Schedule E if they have real estate rental income. Okay, now, the Schedule C and the Schedule E are the sole proprietorship is the automatic designation for taxes for a single member LLC. But the owner has the capacity to tell the IRS, “IRS I want my single member LLC, I don’t want it to be a sole proprietorship for taxes, I want my single member LLC to be considered an S CORP for my taxes or to be considered a C Corp. For my taxes. If you change it to an S CORP, then you file form 1120 s or if you file as a C Corp, you file form 1120 for your business taxes, okay, now if you open up an LLC with two or more owners, the automatic designation for taxes is that the IRS considers your LLC a partnership You need to file taxes under form 1065. And you have the same option, you can tell the IRS that you need to change your multi member LLC to file taxes as an S CORP or as a C Corp.
Okay, so your LLC legally is an LLC, but your LLC, for tax purposes can file taxes five different ways. Your LLC can file taxes on their Schedule C, on their Schedule E, under the 1120S, under the 1120, or the 1065. So here you can see that you can open up an LLC, which is going to be your legal business structure, but your LLC has tax structure options, you can choose how your LLC files taxes based on what your LLC does, how many members if the owners are foreigners, there are many, many options for LLC to file taxes.
Now, if you want to know in detail how each of these five ways affect your taxes, we did a video in the past called The Five Ways an LLC Can File Taxes. We are putting the link for that video on the top right of this video right now. And we’re also going to put a link to this video in the description of this video. Okay, so it’s a very good video for you to see. Very good information.
Now let’s go into the Corporation tax structure. Okay, remember, you can open up an LLC as a legal structure. And you can open up a corporation as the legal structure you can the Corp or the Inc is the same thing. Okay. Now, for a corporation, if you open up a corporation with one owner, the automatic designation for taxes is that you are a C Corporation, and you file taxes under form 1120. Okay, but you also have the option of telling the IRS, “IRS, I want my C Corp. to file taxes as an S CORP. Okay, and to file taxes under form 1120 s. All right. Now, if you open up a corporation with two or more owners it is the same thing. Okay. The automatic designation is a C Corp, but you can choose to pay taxes as an S CORP. Right. So here you can see that if you have a corporation legal business structure, your corporation can file taxes as a C Corporation, and an S Corporation. Okay.
Now let’s go into the tax benefits or tax advantages of the LLC, and the tax benefits and the tax advantages of the Corporation. Okay, so let’s start with the LLC. When you open up an LLC, with one owner, remember that the IRS says that you are a sole proprietorship and that you need to file taxes under Schedule C or Schedule E if you’re doing rental income. Okay, how does Schedule C work? You report your business income during the year. And during the year you have all your expenses. And at the end of the year, you have your net profit or your net loss. Okay, now, this is the LLC. Now this is the owner’s personal tax return which is form 1040. Okay, this net profit, right, flows through the owner’s personal tax return and is added to the household income. Okay.
Now this net profit that gets reported on the owner’s personal tax pays the federal tax rate, the individual federal tax rate, which starts at 10%. And you pay self-employment tax, which is 15.3% in taxes. That 15.3% is composed of Medicare and All of it is mostly Social Security. Okay? Now, this 10% tax rate that you pay on the net profit can go all the way up to 37%. Why? Because it is subject to the household income. So, if your household has higher income, then you’re going to pay a higher tax rate here. Okay. So that’s the way the LLC works for taxes under the Schedule C.
Now, what happens when you change it over to an S CORP? Okay, let’s talk about that. So, remember, you can tell the IRS that you want your LLC to pay taxes as an S CORP under formula 1120S. Okay. Now, how does that work? Your company makes sales, you have all your expenses, and you have your net profit or loss at the end of the year. Okay. Now, under the S CORP, this will also flow into the owner’s personal tax return. Okay. Now remember, under the Schedule C, you had to pay the federal tax that starts at 10%. And you also have to pay the self-employment tax that is 15.3%. Under the S Corporation, the tax benefit is that you don’t pay self-employment tax, and you only pay the federal income tax on the LLC, on the net profit of the LLC. So that is an automatic 15.3% reduction in taxes. So that’s a lot.
So, you may ask yourself, well, if you get an automatic 15.3% reduction in taxes, why doesn’t every LLC that files under Schedule C change it over to an S CORP. is because when you let me show you when you have a Schedule C when your LLC files under Schedule C, okay, the Schedule C, basically, is the simplest tax form for a business, the Schedule C is a very economical form, you don’t have to have any kind of elaborate accounting, you can do everything at the end of the year, the owner doesn’t have to pay himself and payroll. So, it’s a very economical business structure especially for businesses that are starting out. Okay.
Now, once you change from S, Schedule C, to an S CORP and fall under 1120S, the 1120S form is a lot more complex. It’s not that economical, said to be more expensive to fill out. The accounting needs to be a little bit more elaborate. So, your accounting is a little bit more, you have to pay a little bit more for your accounting. The owners of the LLC if they are an active owner on an S CORP. You have to pay yourself under payroll. Okay, well, I spelled that wrong. Let me do this again. Okay, so what does that mean? So, the S Corporation, you have to have most likely monthly bookkeeping service, a payroll service, you need to file quarterly payroll reports, send in quarterly payroll tax payments. At the end of the year, the tax return is a little bit more expensive than the Schedule C. So, for an S CORP. During the year, you have a lot more expenses compared to the Schedule C but the amount of taxes that you save Remember, you automatically save 15.3% in taxes, the amount of taxes you save is so much that it makes sense to have all these extra business expenses during the year. So, I can save taxes at the end of the year.
Now what do we usually recommend? If you have an LLC, file the Schedule C. Okay. And your net profit, annual net profit is $40,000 or more, then it makes sense to change over to an S CORP. But if your net profit of your LLC is $40,000 which basically under the Schedule C is line 31. If the line 31 of your Schedule sees under $40,000, then most probably you would be better off keeping your tax structure as a Schedule C. Okay, so that’s the way the LLC taxes work under the Schedule C, and under the S Corporation.
Now, what happens to the corporate tax structure? Remember, we talked about the LLC. Now we’re going to talk about Corporations, and the tax benefits. So, remember, when you open up a corporation or an Inc, the IRS says that you need to file taxes under formula 1120. How does that work? Your corporation makes sales, you have all your expenses during the year. And at the end of the year, you have your profit or your loss. This is the corporate tax return. This is the owner’s personal tax return 1040. Now, under 1120, this net profit doesn’t flow into the owner’s tax return. The corporation pays right now the corporation pays a flat 21%, which is the corporate tax rate at this time in the US, that may go up in the future since the current administration wants to raise that to 28%. Okay. But it doesn’t flow into the owners, personal tax, the owner only needs to report from the money that comes in whatever the owner pays himself, then that’s how much the owner reports on his personal income tax, but he doesn’t report the net profit of the business. Now, for C Corporations, the active owners of the C Corporations most likely have to pay themselves in payroll as well, depending on your case, okay.
Now, what happens here under the S CORP, remember that you can tell the IRS that you want your C Corp to file taxes as an S CORP. And instead of filing form 1120, you file form 1120 s. You have your sales, you have your expenses, you have your net profit, but the S Corporation does not pay corporate taxes. Okay, this net profit flows through the owner’s personal tax return and you pay then the federal tax rate individual federal tax rate that starts at 10%. But remember that you do not pay the self-employment tax of 15.3%. That’s the advantage of the S Corporation. Okay.
Now, many individuals don’t want, depending on the case, they don’t want this. Also sorry, under the C Corporation, if you file the 1120, meaning that there’s no flow through and meaning that the corporation pays the 21% corporate tax rate. Under the C Corporations at some point, the owner must pay himself a dividend. Okay. And then that dividend pays taxes here and here; so double taxation. Okay. So, depending on your case, a C Corp is good, usually C Corp is better for higher income households is better than the S CORP. Also, there are certain business owners that they don’t want this net profit to get reported on their personal tax return for a lot of reasons. Also, if you are a foreigner, usually the tax strategy for a foreigner is to change it to a C Corp, so that the Corporation pays the taxes and that you don’t have to pay social security taxes on your personal tax return because you’re a foreigner, you don’t have a social security and you want to avoid paying the house Social Security taxes because basically, if you’re a foreigner you would be paying a tax that you see no benefit from.
So, there you can see that there are a lot of strategies, if it’s better for you to be a C Corp or an S CORP. Okay, so that’s the way corporate taxes work on the corporate legal structure. Okay. Now remember that depending on your case, you have a lot of options for taxes, especially if you have an LLC. So, depending on your case, you want to talk to a tax professional to see in your specific case, what’s the best tax structure for your LLC or for your corporation.
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