Should my business be an LLC or an S-Corp?

Two questions wearing one coat

People asking this are usually asking two things at once. One is a legal question about what the business should be. The other is a tax question about how it should be taxed. They are related, and they are not the same decision.

An LLC is a legal entity. It puts a boundary between your personal assets and the obligations of the business. By itself it says nothing about tax: by default, a single-member LLC is taxed as though the business and the owner were the same person, and the owner carries self-employment tax on the profit.

An S-Corp is not an entity at all. It is a tax election. You do not form one — you form an LLC or a corporation and then elect to have it taxed that way. Which is why the answer to the question as asked is often 'both': an LLC, taxed as an S-Corp.

You do not form an S-Corp. You form something else and elect to be taxed as one.

What the election actually changes

Somebody self-employed pays into Social Security and Medicare on their net earnings themselves — both halves of it, where an employee splits that bill with an employer. For most owners it is one of the largest single lines on the return.

Under the election, money coming out of the business is split in two. A salary, which carries payroll tax. And distributions of what is left, which do not. That split is the entire mechanism. Everything else about this decision is about whether the split is worth what the structure costs to run.

The salary is not a free choice

The IRS knows about this and has a rule for it: an owner-employee takes a reasonable salary before taking distributions. You cannot pay yourself almost nothing and call the rest a distribution. A salary set unreasonably low can be reclassified, with back payroll tax and penalties attached to it.

Reasonable means what you would have to pay somebody else to do the work you actually do. What that is depends on the role, the industry and what comparable work pays. Getting this number right is the main compliance obligation the election brings with it, and it is the part most worth having somebody else's judgement on rather than your own optimism.

What it costs to run

The election is not free. It means running payroll for yourself, which means either a payroll service or the time to do it properly. It means more bookkeeping, corporate formalities that have to actually be kept, and a more involved return.

So the comparison is not 'does this reduce payroll tax' — it does — but 'does the reduction beat what the structure costs at my level of income'. Below a certain profit the answer is usually no. Above it the answer is usually yes, and the gap widens as income rises. Where that line falls for you is arithmetic rather than opinion, and it is worth doing with your own figures instead of somebody else's rule of thumb.

The state layer

Federal is only half of it. In Rhode Island a registered entity generally owes a minimum amount at state level whether or not it earned anything — which is also why a company somebody stopped using but never closed keeps accruing quietly. How each structure is treated at state level belongs in the comparison alongside the federal side.

If you have a dormant entity sitting out there, mention it. That is usually worth cleaning up rather than leaving alone.

How the decision gets made

It is not one-size-fits-all and it is not permanent. The right answer at one level of profit is not automatically the right answer at twice that, and a business that has grown is worth re-checking rather than assuming.

The questions are plain. What is the net profit now, and where is it heading? What is a reasonable salary for the work you actually do? What would the payroll tax difference be on the remainder? What would the election add in administration and fees? Does the first number beat the second at your level today, and will it next year?

PSC walks through that comparison with every client for whom the question is live, and models it against real figures.