LLC vs. S Corp: A Guide to Saving on your Tax

A lot of us work really hard throughout the year only to have that dreaded anxiety all the time around tax season. It sucks, watching so much of your hard-earned money leave your account to the tax system. Let’s not break down wailing about it just yet, because as always we’re coming to you with a solution! This is a topic that should be taught in school but isn’t so strap in freelancers we’re getting a lesson in our finances. 

Two of the most common options are the Limited Liability Company (LLC) and the S Corporation (S Corp). While both structures offer significant benefits, particularly in terms of liability protection and tax flexibility, understanding the key differences between them can help you make an informed decision that optimizes your tax savings.

Let the class begin! 

Understanding the Basics: LLC vs. S Corp

At its core, an LLC is a flexible business structure that provides liability protection to its owners, known as members. This means that, in most cases, your personal assets are protected from any debts or lawsuits that your business might incur. An LLC is relatively easy to establish, requiring minimal paperwork and compliance compared to other business entities. The taxation of an LLC is also straightforward; by default, it is treated as a “pass-through” entity, meaning that the profits and losses of the business pass through to your personal tax return. This means that you pay taxes on the net income of the business, along with self-employment taxes, which cover Social Security and Medicare contributions.

An S Corporation, on the other hand, is not a business structure in and of itself but rather a tax designation that can be applied to either an LLC or a corporation. Electing S Corp status can offer distinct tax advantages, especially for freelancers who generate significant income. Like an LLC, an S Corp provides liability protection to its owners, who are referred to as shareholders in this context. However, the primary appeal of an S Corp lies in its potential to reduce your overall tax burden, particularly by minimizing the amount of income subject to self-employment taxes.

Taxation: The Key Differentiator

Tax does most of our heads in, it is arguably the most daunting and anxiety-inducing part of being self-employed. However, once you know what is going on, there are many ways you can help set yourself up for success and savings! 

The taxation of LLCs and S Corps is where the most significant differences—and the greatest potential for tax savings—emerge. As mentioned earlier, an LLC’s income is subject to self-employment taxes. This means that all the business’s profits are taxed at a rate of 15.3%, which covers both the employer and employee portions of Social Security and Medicare taxes. For freelancers, this can represent a substantial portion of your income, especially as your business grows and generates more revenue.

On the other hand, an S Corp allows for a different approach to taxation. When you elect S Corp status, you must pay yourself a reasonable salary, which is subject to the same self-employment taxes as an LLC. However, the key difference is that any remaining profits, known as distributions or dividends, are not subject to self-employment taxes. This structure enables you to significantly reduce the amount of income that is subject to the 15.3% tax rate, potentially resulting in considerable tax savings.

How S Corps Can Save You Money on Taxes

Let’s explore how these tax savings work in practice because this stuff makes my head whirl unless I see it in practice. Imagine your freelance business generates $100,000 in net income for the year. If you operate as an LLC, the entire $100,000 would be subject to self-employment taxes, resulting in a tax bill of approximately $15,300, in addition to any income taxes owed. However, if you elect to be taxed as an S Corp, you can structure your compensation differently. Suppose you decide to pay yourself a reasonable salary of $60,000, with the remaining $40,000 taken as a distribution. In this scenario, only the $60,000 salary would be subject to self-employment taxes, resulting in a tax bill of approximately $9,180. The $40,000 distribution, however, would not be subject to self-employment taxes, saving you about $6,120.

These savings can accumulate year over year, providing you with more capital to reinvest in your business or allocate towards personal financial goals. The larger your business grows, the more pronounced these tax savings can become. It’s important to note that while the IRS requires you to pay yourself a reasonable salary, this amount is based on industry standards and the specific work you perform for your business. Therefore, it’s possible to optimize your salary and distribution ratio to maximize your tax benefits while remaining compliant with IRS regulations.

There are Even More Tax Advantages for S Corps

The good news doesn’t stop there! Beyond the savings on self-employment taxes, S Corps offer additional tax advantages that can further reduce your overall tax liability. One such benefit is the ability to deduct health insurance premiums. If you own more than 2% of an S Corp, you can deduct the cost of your health insurance premiums directly from your wages, which can lower your taxable income. This deduction is reported on your personal tax return and can provide substantial savings, particularly for freelancers who purchase their health insurance independently.

Another significant advantage of an S Corp is the potential for retirement plan contributions. As an S Corp owner, you can set up a retirement plan, such as a Solo 401(k), which allows for higher contribution limits compared to traditional IRAs. In 2024, the contribution limit for a Solo 401(k) is $23,000 for employees under 50, with an additional catch-up contribution of $7,500 for those 50 and older. As the business owner, you can contribute both as an employee and as an employer, potentially reaching the maximum contribution limit of $66,000 (or $73,500 with catch-up contributions) annually. These contributions are tax-deductible, further reducing your taxable income and allowing you to build your retirement savings more aggressively.

To top it off, S Corps can benefit from more strategic tax planning opportunities. By carefully managing your salary and distributions, you can control the timing and amount of your taxable income, allowing for more precise tax management. This can be particularly advantageous if you anticipate changes in your income or tax rates in the future. S Corps can deduct various business expenses, such as office supplies, equipment, and business travel, which can lower your overall tax liability.

The Compliance and Administrative Requirements of S Corps

While the tax benefits of an S Corp are compelling, it’s important to consider the compliance and administrative requirements that come with this designation. Operating as an S Corp involves more formalities than running an LLC, which is a factor that freelancers should carefully evaluate before making the switch. For instance, S Corps are required to adhere to strict record-keeping practices, including maintaining corporate minutes and holding annual shareholder meetings. These requirements are designed to ensure that the S Corp operates as a separate legal entity, distinct from its shareholders.

S Corps must file payroll taxes and issue W-2 forms to shareholders who receive a salary. This means that as an S Corp owner, you’ll need to set up a payroll system, which can involve additional time and expense. S Corps are also required to file a separate corporate tax return (Form 1120S) each year, which reports the income, deductions, and credits of the business. Shareholders then receive a Schedule K-1, which details their share of the S Corp’s income and is used to report this income on their personal tax returns.

These compliance requirements can be burdensome, particularly for freelancers who prefer a simpler, more streamlined business structure. However, many freelancers find that the potential tax savings outweigh the administrative costs. We suggest using quality accounting services such as a skilled accountant (you can find one on our Jobs Board) or using great software like Collective. 

When an S Corp Makes Sense for Freelancers

Deciding whether to elect S Corp status for your freelance business depends on several factors, including your income level, business goals, and willingness to handle additional administrative responsibilities. In general, S Corps are most advantageous for freelancers who generate consistent, substantial income—typically in the range of $60,000 or more annually. At this income level, the tax savings from reduced self-employment taxes can offset the costs of maintaining an S Corp.

If you are looking to reinvest in your business, save for retirement, or maximize your take-home pay you may also find that an S Corp is the better choice. The ability to control your taxable income through salary and distributions provides valuable flexibility, especially as your business grows. Also, if you’re planning to expand your freelance business by hiring employees or seeking outside investment, an S Corp can offer more credibility and professionalism in the eyes of potential partners or lenders.

However, if your freelance income is relatively modest or inconsistent, or if you prefer a simpler business structure with minimal compliance requirements, an LLC might be a better fit. LLCs offer the same liability protection as S Corps but with fewer formalities, making them easier to manage for freelancers who want to focus on their work rather than administrative tasks.

How to Transition from an LLC to an S Corp

If you’ve decided that an S Corp is the right choice for your freelance business, the good news is that transitioning from an LLC to an S Corp is a relatively straightforward process. The first step is to file Form 2553 with the IRS, which is the form used to elect S Corp status. This form must be filed within two months and 15 days of the beginning of the tax year in which you want the S Corp status to take effect. If you miss this deadline, you may still be able to obtain S Corp status by filing the form and requesting late election relief.

Once your S Corp election is approved, you’ll need to adjust your business operations to comply with S Corp requirements. This includes setting up a payroll system, issuing yourself a reasonable salary, and keeping accurate records of your business activities. You’ll also need to start filing quarterly payroll taxes and issuing W-2 forms at the end of the year. Working with a professional accountant can help ensure that you meet all the necessary compliance requirements and maximize your tax savings.

It’s important to remember that the S Corp election is not permanent—you can revoke it if your circumstances change, or you can convert your business back to an LLC if you find that the S Corp structure is no longer beneficial. However, the flexibility and potential tax benefits of an S Corp make it a valuable option for many freelancers.

Making the Right Choice for Your Freelance Business

Choosing between an LLC and an S Corp is a significant decision that can have a lasting impact on your freelance business, particularly when it comes to taxes. While both structures offer liability protection and tax flexibility, the S Corp’s ability to reduce self-employment taxes and provide additional tax advantages makes it an appealing choice for freelancers with substantial income. However, the additional compliance requirements and administrative responsibilities of an S Corp should not be overlooked.

Ultimately, the right choice depends on your specific circumstances, including your income level, business goals, and willingness to handle the complexities of S Corp management. Consulting with a tax professional or accountant can provide valuable insights and help you make an informed decision that aligns with your financial objectives. Whether you choose to remain an LLC or transition to an S Corp, understanding the tax implications of your business structure is essential for maximizing your tax savings and ensuring the long-term success of your freelance career.