Today, I want to talk to you about the differences between an LLC vs an S-Corp and everything you need to know for purposes of taxes.
At what point should you start to transition into an S-Corporation, or should you start to transition to an S-Corporation? Because that is definitely not the route that everyone needs to go, but it is an option for you if you're making a considerable amount of money from your business each month. My goal here is to help you understand the nuances of these very somewhat complex legal terms in a way that pretty much anybody can understand. That's the whole goal of everything I do here with Hawthorn Law.
I've talked about what an LLC is. I've talked about how to start an LLC. You all know the benefits of starting an LLC, but at what point should you start to think about forming an S-Corporation? A lot of people think that an LLC is one thing and S-Corporation is something completely different. That's only partially true. S-Corporation is actually is a taxing status. So when you say you want to become an S-Corporation, which you're really telling the IRS is that you want to be taxed like an S-Corporation. And an S-Corporation is basically a taxing status where you get the income from your LLC flows through to you. And that explains well. Let's go back to basics.
When you form your LLC, basically what you do is you become what's called a disregarded entity if you do nothing else. That means that you've got this legal entity that's going to protect you from liability. And when you file your taxes, you are going to file what's called a Schedule C. You're going to have all your business income and losses on that schedule. And that's going to flow through under your personal tax return. If you have just an LLC and you haven't done anything else, you don't have to file a separate tax return for that. You don't have to file a corporate tax return or anything like that. You just have your regular 1040 that you're going to file. And all the income and losses from your LLC is going to go on that. And what you're going to do is you're going to pay a separate 15.3% tax, that's self-employment tax, that's your FICA, that's your Medicare, that's your social security, that's all that kind of stuff.
It's going to be wrapped into the profit that you received from your LLC. And you're going to get taxed on that. And that's how that works. Now, at some point, you're going to make enough money that you may decide that you want to actually be taxed like an S-Corporation. So, an S-Corporation is a taxing status. So you could be a corporation, and elect S-Corporation taxing status. You could be a partnership, and elect S-Corporation taxing status. Or you could be an LLC, and elect S-Corporation tax status.
Basically what that means is that at the end of the year when you do your taxes, instead of having all that, those income and losses on your 1040 like you would if you were just being taxed as an LLC, by being taxed as an S-Corporation, you'll have to file a separate tax return for the business entity that you've chosen.
You're going to need to pay yourself a salary. And that's how you pay the self-employment taxes. With an S-Corporation, and when I say S-Corporation, you still could be an LLC. I'm just saying you've elected S-Corporation status. With that S-Corporation status, you have to pay yourself what's considered a reasonable salary. What is a reasonable salary? Well, a reasonable salary is if you were to take yourself out of the business and insert somebody into the business to do what you do, how much would you pay them? That's what a reasonable salary is. So for me as an attorney, let's say an average attorney makes, as an employee of a small firm makes let's say $75,000 a year. Well, then that would be a reasonable salary that I should pay myself. I'm not saying that's reasonable for my business and I'm not saying if I make more or less than that. I am just saying that's how much maybe you would pay an associate at a law firm.
If you're a painter, and if you were to put somebody in as a painting business, and if you were to have to hire them full-time to do all the painting, and maybe you pay them $10 an hour, well, that's what a reasonable salary would be for that. So, it's really going to depend on the type of business you're in and the type of work that you would be doing within the business. So, you pay yourself that reasonable salary. Why is that so important? It's so important because by paying yourself a salary, you don't have to pay that 15.3% self-employment tax on anything above the salary. That's all net profit of the business.
This is even more important because of the tax law changes that just went into effect at the beginning of this year. Let's say that you're allowed to deduct 20% of your income from your business operations. Paying yourself a salary, that's not going to be included.
Now that's a full line deduction, right? You're going to be able to deduct all that from your business, so you're not going to be taxed on that separately as profit. I really hope this is making sense. Because even as I talk about this, I realize how complicated this stuff really is. Anyway, the bottom line is, what do you need to know? You need to know that with an LLC, you get taxed on your full profit. So, you pay that self-employment tax on all the profit from the business. With an S-Corporation, you only pay the self-employment tax on the amount you pay yourself as a salary. So if your business earns $200,000, you pay yourself a $50,000 salary. That's the part that you're going to pay the 15% self-employment tax on. Everything above that, the $150,000 is net profit.
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And you get a deduction of 20% of that. So, what's that? $30,000 on top of that, that you're not going to be taxed on at normal income tax rates for your business. Does that make sense? I hope that makes sense.
Other than that, I think that's it. Anyway, have a great day folks. Until next time!