This is a question we at CapForge get all the time and even when it isn’t asked we find ourselves addressing it with clients frequently because it could be saving them money if they switch.
There is a lot of misinformation out there as well as simply misinformed or wrongly motivated advice on how business owners should answer this question.
I find people often make the wrong choice for one of these common reasons:
- They got advice from someone who is in a totally different situation so it didn’t apply but they didn’t realize that
- They went to an online incorporation provider that lets you register yourself as whatever you want without any regard for what’s best
- They got directed to a firm that paid the referrer an affiliate commission but wasn’t necessarily the best fit for giving good advice
- They got advice from an attorney who has an entirely different perspective on these matters than a small business owner is likely going to have
- They just did it the way they did it before, not realizing there was a better option
- They got overwhelmed with info and so just made a decision at the time and hoped for the best
So this article is probably going to be a bit long but will hopefully give you a good basis for answering this question for your own situation with the best possible answer and outcome.
First though, let’s take a second to talk about the various entity options for sellers:
Sole Prop vs. LLC vs. S Corp vs. C Corp
In the U.S., a sole prop (short for sole proprietor) is someone who sells under their own name or just a local registration of a fictitious business name. It’s the simplest form of business, which is good, but it offers you no legal protection of your personal assets and no anonymity. Not really recommended. In other countries, they call this sole trader or other similar names.
An LLC is a U.S. entity type that operates as a separate legal entity (it stands for Limited Liability Corporation) and does offer you protection for your personal assets as long as you don’t co-mingle your business and personal funds and follow the basic rules. LLCs can be owned by one or more people and are pretty simple to set up. The downside of LLCs for Americans is they tend to pay more in taxes as an LLC than as an S Corp. For foreign owners doing business in the U.S., on the other hand, an LLC is usually the best way to go. More on that later.
An S Corp is a special kind of corporation, only available to U.S. citizens and resident aliens, that offers the same legal protection as an LLC but often more tax savings. It also has some additional restrictions, making it not necessarily the best choice for partnerships or businesses with investors. It isn’t available for foreign ownership.
A C Corp is a regular corporation which is good for large companies but generally bad for small companies because of the real risk of double taxation. Sometimes though, if you plan to acquire a business using 401K funds, for example, a C Corp is your only option. It may also be better if there is a mix of U.S. and foreign ownership.
As far as costs to get set up, the states are the ones who decide what it costs to file for any of these entities. In most states the cost to be an LLC is the same as an S Corp or very similar. The paperwork to file is also similar. State by state, however, for states that charge tax on these entities there may be some small differences. In most states the cost is a hundred to a few hundred dollars in filing fees.
One big difference in cost is in California where either one costs $800 per year minimum, but they waive the fee for the first year for an S Corp whereas for the LLC they don’t waive it. One more reason in that state to consider being an S Corp! Also in CA the LLC pays tax based on revenue whereas the S Corp pays taxes on profits, potentially setting up the situation where a money losing LLC owes more in tax than a profitable S Corp. Yet another strike against my home state!
There is lots more info on the differences between these types but it’s not really relevant to this discussion. Let’s just say, for an online seller, a sole prop is not a great choice except maybe when you are really small and just getting started and a C Corp is not a great choice except in a few circumstances where you are forced to be one.
That leaves us with deciding between an LLC and an S Corp or a hybrid option—the LLC that is taxed as an S Corp!
Yes, you can legally be an LLC but for tax purposes be treated as an S Corp. Just to throw that into the mix. Don’t worry though, I’ll get to it.
The way to drill down to the right decision on which of these to be is to answer a number of important qualifying questions:
Where do you live?
If you live outside of the U.S., then you only really can be an LLC or a C Corp. For nearly all of our outside the U.S. clients, the best choice is to be a single member LLC. Why? Because it requires the least amount of tax filings and if you are in a country that has a tax treaty with the U.S., you likely won’t pay any taxes in the U.S. at all. You still have to file, but you won’t have to pay. If you are outside the U.S. and you aren’t planning to have a physical presence in the U.S., then you can pick any state you want to locate your business entity.
The majority of the time, we recommend Wyoming, as it has the lowest fees, easiest filing requirements, and no state tax. If you are going to have an office or staff in a particular state, then you usually will want to set up there to avoid having to file in two states (one where you work and then the one where you registered).
If you live in the U.S., then you really want to register in the state where you live and do business. You can register in another state, but this won’t get you out of paying income taxes in your home state, it will just mean you need to file in both places. If it was that easy, we’d ALL register our businesses in a no tax state and no one would ever pay income taxes to any state. Unfortunately, it doesn’t work like that.
Will you have investors or partners?
Although S Corps often have better tax benefits than LLCs, they also have one significant drawback which relates to how investment and profits are shared. In an S Corp, if there are two or more people who own a piece of the business, then each one must contribute according to their ownership and then they are taxed on profits according to their ownership.
For example, if Joe and Moe form an S Corp and each are 50% owners and Joe puts in $10,000 to get it started then Moe also has to put in $10,000. Likewise, if the business has $20,000 in profits, Moe will pay taxes on $10,000 and so will Joe, even if Moe did all the work and took all the money with Joe’s blessing!
This works fine when there is only one owner or when the owners are happy to contribute and share equally.
If you plan to have an investor or a partner though, an LLC may be better. With an LLC the contributions and ownership and profit distributions can be totally unrelated. Moe could own 90% of the LLC but put in no cash and meanwhile Joe could own only 10% but have put in 100% of the startup cash but only get 20% of the profits. In other words, an LLC can use any system it likes to reward sweat equity and pay investors that is separate from who owns how much of the business.
But… don’t decide to be an LLC just because some day you may want an investor, either!
Unless you actually have a money partner now you have to work with, you may still be better off being an S Corp and then you can still work with an investor in a number of ways:
- Instead of ownership, an investor can contribute a loan which is paid back with interest/profit sharing
- A second LLC entity can be created and sold part of the business the S Corp owns alongside the investor
- The existing business can convert from an S Corp to an LLC
If you know your plan ahead of time you can arrange this better. But if something unexpected comes up, there is often still a way to make it work.
Will you have multiple accounts?
Many of our clients end up starting more than one Amazon business. But Amazon will only let an entity have one account. So the business owner starts another account under a new entity. But should that one be an LLC or an S Corp. S Corps have better tax advantages but LLCs have more flexible ownership rules.
The way many of our clients work it is to have their “parent” business be an S Corp which then owns multiple LLCs, each of which in turn owns the Amazon account.
Each LLC has its own income and buys it’s own inventory, but the parent company pays for the software subscriptions, contractors, etc. and collects a management fee which essentially wipes out the profit in each LLC. That means the profits all flow into the S Corp where they do better from a tax standpoint, but since each account is in its own silo it can be sold easily without interrupting the other companies.
Why not have them all be S Corps? Because an S Corp can’t own an S Corp, but it can own an LLC!
LLC vs S Corp Tax Benefits
There are two main tax benefits that S Corps get that LLCs don’t.
The first is that S Corps that are profitable are required to pay actively working owners a reasonable wage in the form of payroll that has payroll taxes withheld and comes with a pay stub and a year-end form W2.
How is getting paid an advantage? Well, the rule is you pay payroll taxes on whatever you are paid through payroll, but whatever the business makes above that is not subject to payroll tax. It is still subject to income tax, but payroll taxes add about 15% to your tax bill and by being an S Corp you can control and minimize that amount.
With an S Corp, you decide what is a reasonable salary to pay yourself and in the case of an online business, that number can reasonably be pretty low. Let’s say you are a private label FBA seller; your job is to order the inventory from your manufacturer. They make it, you just place the order. Then the shippers ship it to Amazon, Amazon displays it, takes the order, picks it, packs it, ships it, processes the payment, handles the returns, posts the reviews, and then eventually just sends you a check.
A lot of hands are involved in that sale that aren’t you and happen whether you are watching or not. Therefore, you can justify a pretty low wage.
Many of our clients pay themselves $2,000 a month or less even when they are making ten times that amount or more. More volume doesn’t mean more work for them, so a raise isn’t justified. The upside of the low salary is the very little of what they make is subject to payroll tax which means more money in their pockets.
With an LLC on the other hand, all profits are subject to payroll tax until you hit the limit for payroll tax (over $130K)! This means a seller with $100,000 in profit is going to pay $15,000 in payroll tax on top of their income tax! And note: profit happens even when you reinvest in the business and even when you can legitimately say, “I didn’t take anywhere close to $100k out of my business!”
For this single reason alone, an S Corp often makes a lot more sense than an LLC for a business with even nominal profits in the online space, saving the average $100K profit client over $10K in taxes that goes straight into their pockets.
The second advantage of the S Corp is that the owners can have the business pay for their health insurance premiums and claim it as a business expense. If you have a spouse or day job that covers your insurance, great! But if not, and you buy your own, you know how expensive it is.
Having your business pay for it and get the write off can be worth thousands of dollars a year in tax savings versus having to pay out of pocket with after tax money. An LLC does not allow you to do this so this is another big reason to be an S Corp if this situation applies to you.
S Corp Disadvantages
So far I’ve been pretty positive on the pros of the S Corp but we want to be fully transparent here. There are two added expenses to being an S Corp to be aware of and why when you are really tiny or losing money the advantages may disappear altogether.
The first is an S Corp requires a separate tax return. It is a separate legal entity and it files its own tax return called an 1120S. This can be done by you as the business owner, but more often to avoid screwing it up and getting yourself in hot water (or missing easy deductions) you’ll want to hire a CPA firm to do it for you. The average cost for this is about $1,200 to $1,500.
An LLC on the other hand is not going to require a separate tax return as it is done as part of your regular personal return as long as there is only one owner. If there are two or more owners of the LLC then it’s going to be the same as the S Corp return (different form, 1065, but same extra cost). A single person LLC tax return may only add a few hundred dollars or less to the cost of your tax return.
The second added cost of the S Corp is having payroll. Even more than taxes, this isn’t something you want to do on your own as it’s easy to screw up and miss the deadlines and cost yourself more in penalties than a payroll service would have cost. For our clients, payroll service for 1-3 people is $49/month.
When you add up a full year of being an S Corp, the total cost is about $2,000 more than being a single member LLC. So to make sure it’s worth it to be an S Corp, you’d want to save at least that much in taxes, between savings on payroll tax and savings on health insurance, if that applies. For most clients, that means you should be profitable and expecting to net at least $25-$30,000 for the year. Any more than that and you will be more and more ahead by being an S Corp. Less than that and it may not save you much or you may be slightly negative.
Negative S Corp Myths
The two most common reasons I hear people shoot down the idea of a small business being an S Corp usually come from attorneys and are both mostly bogus.
The first one is that S Corps have a much bigger burden of paperwork. It’s true, when you own an S Corp you are required to have an annual shareholders meeting and keep minutes. It’s also true that seems pretty ridiculous when it’s a company of one. But people like to claim this is some huge hassle that takes a lot of time and somehow is such a burden that it offsets the savings.
Not true at all.
I spend two minutes once a year printing out a copy of my last year’s corporate minutes (“minutes” just refers to notes from the meeting), writing “No Change” on it, signing it, and sticking it back in a drawer. Doing the first year one only took a few minutes longer than that. And since no one ever sees this and you don’t file it anywhere and there are no external deadlines to meet, this is really a non-issue.
The second reason I hear people talk about is that S Corps are vulnerable to having their “corporate veil” pierced, which is legal speak for saying that the corporation loses its ability to shield your personal assets because you didn’t treat it properly as a separate entity.
Here’s the thing: it’s very, very hard to find any case studies of a corporate veil actually being pierced except in cases of such blatant fraud and criminal activity that it’s impossible to defend your behavior. In the Wikipedia entry linked above, they list five court cases examples of it, ranging from 1927 to 1991 and one of those was a rejected case.
But in day-to-day cases with small businesses, it just isn’t a thing you see. Every time I run across a lawyer now I always ask, “Just out of curiosity, have you or anyone you know ever been in a case where a corporate veil got pierced?” And no one has ever answered yes! Yet when you hear some lawyers talk about this to clients asking about setting up S Corps they make it sound like it happens about as often as traffic tickets.
I’ve been in business working with small business owners for over twenty years and have spoken with thousands over that time and not one has ever had this happen. So while it’s not impossible, I’d say as long as you aren’t launching a criminal enterprise, this is not a reason not to consider an S Corp!
The LLC with an S Election
I alluded to this before and wanted to come back to it here. What if you want to be an S Corp but you are already an LLC? There’s a way to do that (assuming you are otherwise qualified to be an S Corp)!
The IRS will let you file what’s called an S Election (form 2553) which says to them “Legally I know I’m an LLC, but for tax purposes, please treat me as if I am an S Corp.”
What this means is that you keep your LLC name and your EIN and everything else stays the same, but for tax purposes you will file the S Corp form (1120S) and be held to S Corp rules. Once you do this you now must match contributions and distributions like an S Corp would and you have to pay yourself payroll. You also get to have the benefits of being an S Corp which is exemption from payroll taxes on distributions and the ability to have the business buy your health insurance.
Ideally you’d file the S Election at the start of a new year, but for practical purposes you can file it any time and back date it to the start of the year. That said, don’t wait until December because you need enough time to get payroll set up and going. There is a special process for filing a late S Election but generally as long as you follow the steps the retroactive treatment will be accepted. The reason to back date it is so you get the benefit of the S Corp for the whole year and also so you don’t need to file two tax returns in a single year, one for the LLC portion and one for the S Corp portion.
The S Election also works if you are a C Corp and would rather be an S Corp as long as you qualify to switch.
OK, So What to Pick?
Here’s the short cut guide:
You’ll want to be an LLC if:
- You are a foreign owner
- You need to split the investment and profits differently than the ownership percentages
- You know for sure you’ll be raising money from equity investors
- You are adding another entity to own an account under a parent business
- You already are an LLC and just want to choose the S Election for tax purposes
You’ll want to be an S Corp if:
- You are a U.S. citizen or resident alien
- You are a sole owner, husband and wife, or partners with equal contributions
- You pay for your own health insurance
- You haven’t formed anything yet so you can go straight to being an S Corp
Still have questions or want a specific review of your situation? No problem, just shoot us an email or give us a call. It’s hard to write a one-size-fits-all article that covers all the possible scenarios which is why we always advocate having a conversation with someone who knows what they are talking about before making these decisions.
I also want to point out I am not a lawyer, and although I’ve been doing this a long time and probably done more of these than 99% of lawyers out there, this is not legal advice! We do, however, have CPAs in our office so we can provide you licensed accounting advice.
The accounting and tax savings is going to be where the real value comes in with changing your entity year-after-year so it’s definitely worth a conversation. We can also help you set up a new entity or convert your LLC to being taxed as an S Corp if that makes sense for your situation. It all starts with a conversation to figure out what’s best for you, so give us a call or send us an email and let’s chat!