Could an LLC or S Corporation Save You Money on Your Taxes?

If you’re a sole proprietor and are reeling at the amount of self-employment and income tax you pay, then it may time to review your business status.

Sole proprietors make up the majority of all U.S. businesses, and there’s good reason: it’s the easiest business structure to form and operate. However, it’s also far from being the most financially advantageous for many. Sole proprietors often pay more tax in proportion to their income when compared to other business structures, like LLCs and corporations. Your business may be growing, but to fully benefit from that growth, the structure of your business matters a lot.

Sole Proprietors are Taxed on Everything

As a sole proprietor, you’re required by law report all income on your personal income tax return. Your business itself is not taxed as a separate entity. If you are a sole proprietor, you are taxed on all profits of the business (income minus expenses), whether you spend that money yourself or leave it in your bank account to reinvest in your business at a later date.

You are also responsible for paying self-employment tax, which covers your Social Security and Medicare obligations. And here comes the big problem for sole proprietors: you must pay the entire amount yourself. If you were an employee of a company, half of those expenses are matched by employers. Essentially you are paying both personal and business tax on your income.

Is an LLC or S Corporation a Better Option?

Now compare this structure with that of an LLC or S Corporations (also called S Corps). These legal entities are similar in that both separate your personal and business assets. Both also offer liability protection, meaning if creditors come after your business they can’t touch your personal assets.

But that’s where the similarities end.

When it comes to taxes, LLC are typically taxed the same way as sole proprietorships, so while it can help you out with liability concerns and give you a more secure legal footing, it won’t make a big difference in your taxes. You’re still subject to employment tax on your entire net income.

On the other hand, one of the best features of the S Corp is tax savings for both you and your business. According to the IRS, S Corps are “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S Corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.”

With an S Corp, you as the owner may be treated as an employee. That means, you can draw a salary from the profits of your business, and only those wages are subject to self-employment taxes. Any profit that remains is then distributed to the owner(s) as dividends. Dividends are taxed at a lower rate than income, which could potentially reduce your total annual tax liability.

An S Corporation is a popular choice for small businesses or freelancers with profits between $80,000 and $100,000. It’s also an attractive option for businesses looking to take on investors, and it can improve your chances of getting approved for a small business loan. From an investor or lender perspective, incorporating a business creates more separation between the business and the owner, which helps reduce some risk. If you do decide to apply for business funding, you may be asked to provide your “entity type”—meaning, you’ll need to tell the lender whether you’re an LLC, an S Corp, or some other type of entity.

Don’t Make the Decision Alone

It’s not a decision to be made lightly and there are a lot more distinguishing features to each legal structure than we could possibly capture here.

For example, S Corps are much more complex and expensive to set-up and run than sole proprietorships or LLCs. The process of incorporating a business varies by location, while setting up an LLC is comparatively simple. To make things more complicated, you can even request S Corp status for an LLC!

Whether changing your business from a sole proprietorship to an S Corporation can save you money (and how much) will depend on your particular situation. If you’re not a tax expert, it’s a good idea to ask a trusted financial advisor about this before deciding what to do. Talk to your accountant or tax advisor to understand the options and make the smartest choice for your business.

Irene Malatesta is a business content strategist with Fundbox, working with entrepreneurs and mission-driven businesses to bring their stories to life. Fundbox is dedicated to helping small businesses grow by democratizing access to credit.

Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.