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Should Your Online Service Business Be an S-Corp?

May 23, 2023
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Should Your Online Service Business Be an S-Corp?

Last week we talked about the different kinds of legal entities you might consider for your online service business. We covered sole proprietorships, corporations, limited liability companies and partnerships. You can catch up with that blog here: Two Step Process to Choose a Legal Entity to Conduct Your Online Business.

One question I get asked a lot is, “Should I form an s-corp for my business?” There’s a lot of confusion about what an s-corp is, and whether or not you’d want to use one for your business. Let’s break down what an s-corp is, why business owners choose them, and factors to consider to convert your online business, including an LLC, to an s-corp.

What is an S-Corp?

Before explaining what an s-corp is, it’s important to understand what an s-corp is not. An s-corp is not a separate kind of legal entity. Yup, you read that correctly.  An s-corp is not a separate legal entity. Instead, an s-corp is a tax election that you can make for your online business. Legal entities, like corporations and limited liability companies, are formed under state law. Each state has statutes that allow business to be conducted through legal entities like corporations and limited liability companies. By choosing to form a legal entity, the business owner gets certain benefits as described in the statute, one of which is limited liability protection. 

Once a business owner has formed a corporation or limited liability company, then the business owner can make choices about how the income earned by the business should be treated for tax purposes. This is where the s-corp election comes into play. In the Internal Revenue Code, which is the federal statute governing income taxes, Subchapter S sets out the rules that businesses can follow if they want to adopt s-corp tax treatment for their businesses. To understand why a business might want to make an s-corp election, let’s review how the federal tax system works.

Income Taxes and S-Elections for Your Online Service Business

Under our federal tax system, individuals and businesses that earn income pay taxes on that income. In last week’s blog, we reviewed that limited liability companies have pass through tax treatment, meaning that income earned by the LLC is reported on Schedule C of the owner’s federal tax return. Corporations, on the other hand, are not pass through entities by default. Instead, if a corporation earns income, the corporation owes federal taxes on its net income. Corporations are said to be subject to double taxation because the net income of the corporation is subject to federal income tax, and then any distributions to its owners are also subject to tax. In effect, this means that the same income is taxed twice - once at the corporate level and again at the individual level.

To ease the burden of double taxation, Subchapter S of the Internal Revenue Code was enacted to allow small businesses to make a tax election so that the income earned by their corporations could be treated as pass through income, and taxed only once on Schedule C of the owner’s federal income tax return. When a business owner decides to set up a corporation as the form of legal entity, the owner incorporates that business in a specific state. By default, the corporation is classified as a “C” corporation, meaning that the income earned is subject to double taxation. The decision to be taxed as an s-corp instead of a c-corp is a federal tax election, and doesn't change the legal structure of the corporation under the laws of the state where it was formed.

Limited Liability Companies Can Be Taxed as S-Corps

A limited liability company can also make an election to be taxed as an s-corp. In the same way that a corporation maintains its legal status under the law of the state where it was formed, the same is true for an LLC making an s-corp election. The LLC is still an LLC and has the legal structure of an LLC, but for federal tax purposes it’s taxed as a corporation that has made an s-corp election.  This can be a confusing concept, because on the one hand the business is an LLC under state law, but on the other hand it’s an s-corp for tax purposes.  Let’s explore some of the reasons for making the election which will help clarify the distinction between the legal entity and its tax status.

Why Choose S-Corp. Status for Your LLC

Many online businesses choose the LLC as their choice of legal entity to operate their business. As a legal structure, LLCs are easy to set up and operate and don’t have the complexities and formalities of corporations. But at a certain level of income, it may be more advantageous to the business owner for the LLC to elect s-corp tax treatment. 

When a business operates as an s-corp, the profits and losses "pass-through" to the business owner’s personal tax returns and reported on Schedule C, where she is taxed at the individual income tax rate. This means that the business itself does not pay federal income taxes, and instead the business owner reports the income and pays the taxes.

The tax savings associated with an s-corp primarily come from avoiding self-employment taxes. For businesses with pass-through tax treatment, like sole proprietors or LLCs, the business owner is subject to self-employment taxes on the net income of the business. These taxes can be significant, as they are currently set at a rate of 15.3%, which includes both Social Security and Medicare taxes. Sole proprietors and owners of LLCs, usually called members, are not employees of their businesses. Instead, they are paid as owners and the net income flows directly through to Schedule C of the federal income tax return. 

If a business is operating as a corporation, then the business owner is an employee of the corporation, and is treated for tax purposes like any other employee of the business. This is true whether the business is a corporation under state law, or an LLC under state law with an election to be taxed as an s-corp. The business needs to withhold income taxes, pay payroll taxes, purchase workers’ compensation and unemployment insurance and comply with other requirements for having employees. However, with an s-corp election, the business owner gets to split her income between salary that is paid to her as an employee, and distributions of the remaining amount of the business’ profits. S-corp owners are not subject to self-employment taxes on the business's profits, but they are required to pay themselves a reasonable salary and subject it to payroll taxes. This allows business owners that have made an s-corp election to save on self-employment taxes by paying themselves a reasonable salary and taking the remaining profits as a distribution, which is not subject to payroll taxes.

The tax savings from avoiding self-employment taxes can be significant, especially for businesses with a net income of at least $50,000 per year. For example, a business owner operating an LLC with a net income of $60,000 would pay approximately $9,180 in self-employment taxes. However, if the same business owner elected s-corp status, this business owner could potentially save approximately $4,590 in self-employment taxes by paying herself a reasonable salary and taking the remaining profits as a distribution.

Do I have to Choose S-Corp. Status for My LLC at the Beginning?

An LLC does not need to select s-corp status at the time of formation. The election can be made later, once the income of the LLC reaches a certain level where it might make sense to incur some additional expenses and burdens of being taxed as an s-corp in order to achieve some tax savings. In most cases, the structure of your LLC will not change if you make an s-corp election later, and you won’t need to obtain a different EIN. The specifics of properly making an s-corp election, the timing of making the election, how it will apply to your current tax year, and how s-corps are treated under your state’s laws are topics to review with your tax advisor so you can account for your unique circumstances. 

S-corps are also subject to some restrictions. For example, the business must be formed in the U.S., have only one class of ownership interests, like stock or membership interests, and have no more than 100 owners. Additionally, all owners must be U.S. citizens or resident aliens, and the business must use the calendar year as its fiscal year.

As with many business decisions, there are trade offs to consider before making an s-corp election for an LLC. While an LLC with an s-corp election can potentially achieve tax savings, there are additional costs associated with maintaining s-corp status, such as filing annual tax returns and paying additional payroll taxes. Whether the LLC for your online business  is operating at a level financially where it might make sense to make an s-corp election is a conversation to have with your tax advisor, based on your specific circumstances and goals.

Are you looking for customizable legal contract templates to Step Up Your Legal™ in your online service business?  Head on over to the template shop with the link above and check out our selection.