The two most expensive things in life are taxes and interest, and we want to avoid both. One of the best ways to avoid taxes is by starting a business.
Today we will discuss LLC vs. S Corp and the amazing tax benefits that come with it.
We want to illustrate the massive tax advantages allowed to small businesses and how utilizing these advantages can be as beneficial if not more so as compared to traditional retirement accounts. Also, they can be used in conjunction with retirement accounts for a significant advantage.
Anyone Can Do It
A long time ago, we did an episode with Natali Morris about turning your family into a business. It inspired me to set up an LLC as LMM had advised me to do.
Today we want to encourage many of you to start an LLC or S Corp to reap that tax advantages of doing so.
If you have a hobby, you have a business. We did an entire series about starting a business that, with just a few hours of work a week, will make you $1,000 a month within a year.
And bringing in some extra money is far from the only incentive to start a small business.
Incorporate your family and create your personal LLC. Use it to save on taxes and grow your income. Unsure what to do and nervous you're going to mess up? Don't let it prevent you from building something, let these guys take care of it.
Uncle Sam Wants You To
Small businesses drive the US economy, and our tax law is set up to incentivize and reward business owners. Many of us knew that, but the numbers might surprise you. Almost 100% of US employment firms are made up of small businesses, 99.7%.
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There are 5.9 million firms with at least one employee and 3.6 million with fewer than five employees. There are less than 20,000 companies in the US that employ more than 500 people.
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There are a few ways to make a business official so you can start reaping all those juicy tax benefits, but an LLC, a limited liability corporation, is the simplest and the most flexible.
One of the most significant benefits of an LLC is that of pass-through taxes. LLC owners don’t have to file a corporate tax return. An owner reports their share of profit and loss on their individual tax return.
This prevents double taxation, your business paying taxes, and you paying taxes. In an LLC, the business doesn’t pay any taxes, only the owner.
Once you have set up an LLC, you have created a separate legal entity. This protects you and your personal assets. The LLC is solely liable for its debts and obligations; the owner of the LLC is not.
If the LLC were to be sued by a creditor, that creditor could only go after the LLC’s assets and not the owner’s.
Your Life is Cheaper
Having an LLC makes your expenses less expensive. A cell phone is an excellent example of this.
A cell phone plan that costs $100 a month is $100 a month if you run a business. If you are a W-2 employee working for the man, you are paying for that cell phone with post-tax money, so you actually need to earn $125 to cover that bill.
Essentially, for every $1,000 in business-related expenses, you’re paying $250 more as a W-2 employee than you would be if you started a business and set it up as an LLC.
These expenses include everything it takes to run your business; your cell phone, internet, electricity, and if you’re LMM, beer!
If your spouse is involved in the business, guess what? Date night dinners just got 50% cheaper so long as you spend part of the meal discussing business.
You Win When You Lose
What if your business isn’t making a profit? Your initial losses are still beneficial. LMM is an example.
It took LMM about two years to declare a profit, during which time Andrew was not paying himself. The third year, it made a profit, but not much during the time that he was investing in the business.
He was able to use LMM’s losses against his personal income. That incentive to invest in growing your own business is pretty compelling.
The return on investment, which is technically tax-free, has been far higher for Listen Money Matters, Investable, and Laura’s Poshmark business. We have no doubt it will remain true for two new businesses Laura and Andrew are currently incubating.
How long do you have to start making money? The general rule is that if you have not turned a profit in at least three of the prior five years, the IRS will categorize your business as a hobby.
LLC vs. S Corp
LLC’s and S Corp’s have some similarities and some key differences.
- Limited liability protection. Business owners are generally not personally responsible for business debts and liabilities.
- Separate entities. LLC’s and S Corp’s are separate legal entities created by filing papers with the state.
- Pass-through taxation. Both are generally pass-through tax entities, but S corps must file a business tax return. An LLC must only file a business tax return if there is more than one owner.
- Ongoing state requirements. Both are subject to state-mandated requirements, like filing annual reports and paying the required fees.
- Members: LLCs can have any number of members; S corps must have 100 shareholders or fewer.
- Citizenship/Residency: LLC members don’t have to be US citizens or residents. S Corp shareholders must be citizens or residents.
- Self-employment taxes: This is the big one guys. S Corps have more advantageous self-employment taxes than LLC’s. S Corp owners can be considered employees and paid “a reasonable salary.” FICA taxes are taken out and paid on the amount of the salary. Corporate earnings after salary may be able to be treated as unearned income that will not be subject to self-employment taxes.
Making the Switch
There is an area in the battle between LLC vs. S Corp, where the S Corp is a clear winner.
The self-employment taxes are the significant benefit to having an S Corp over an LLC, but because an LLC is so much simpler, start there.
Except for a business whose sole income is directly tied to your hours like consulting, you can convert your LLC to an S-Corp and get those tax benefits.
It would only really make sense to convert to an S-Corp once you’re earning a meaningful amount of money, probably over $100k, in our opinion, although Laura and Andrew waited nearly twice as long. They switched once they were running full payroll for themselves.
By paying yourself a “reasonable salary,” all income above that reasonable salary, you can take as a distribution saving yourself social security and Medicare taxes, effectively saving yourself a little over 15%.
What is a reasonable salary? There’s a ton of debate on this out there, and while you can essentially make this up, I wouldn’t suggest it. Most people seem to index their salaries to Payscale or Glassdoor. Lucky for us, their salaries are pretty low.
For payroll, we use Gusto because it’s cheap and self-service. Until things became stable, I found myself frequently updating my salary (both up and down) – Gusto makes this super easy and guilt-free. They even show the tax consequences.
Businesses need to run payroll. Gusto is an affordable modern payroll platform that you can fully control online, and love it. They will even help you with a 401k, IRA or HSA. Gusto's also incredibly affordable.
What Is the Self-employment Tax Rate?
You have to pay taxes on your total net earnings every year. For self-employment income earned in a particular year, the self-employment tax rate is 15.3%.
The rate consists of two parts: 12.4% for Social Security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
The Social Security portion is capped at a maximum amount, which changes each year. If your net earnings exceed the maximum that that year, you continue to pay only the Medicare portion of the SECA tax.
How does that compare to a W2 employee?
The 2018 Federal tax bracket for a married filing jointly couple earning $100,000 is 22%. The 2018 New Jersey tax bracket for a married filing jointly couple earning $100,000 is 5.53%
That means a W2 employee is paying a total tax rate is 27.53%, not counting deductions to keep things simple, compared to just 15.3% for a self-employed person. How does it compare? It doesn’t. You shouldn’t need any more convincing to start your own business.
You might feel pretty lucky to have an employer-sponsored 401k at your job and a Roth IRA, but the retirement account benefits to having your own business are infinitely better!
The SEP-IRA is a monstrous tax cheat code. It’s a way for the self-employed who don’t have access to an employer-sponsored 401k to save for retirement. A SEP IRA has a much higher contribution limit than a Roth IRA and is much more flexible than a 401k.
A business owner can contribute up to $53,000 per year. The 2018 limit for Roth contributions is a meager $5,500. Owners can deduct 100% of that $53,000 from their business earnings.
This contribution is essentially pre-tax, and you can invest in pretty much anything, including rental property, unlike a 401k, which is limited to the funds your employer offers, many of which often have very high fees which eat up your retirement savings.
IRA’s and 401k
You still can potentially qualify for the regular IRA’s, Traditional and Roth, and you can even run a 401k through your company bringing your potential tax-advantaged earnings to:
- $53,000 for a SEP IRA – tax-deferred.
- If you qualify, you can contribute up to $5,500 to a regular Roth or Traditional IRA.
- Your business can match 100% of 401k contributions you make up to 3% of your salary. On $100k, that’s $3,000 from you and $3,000 from your business all tax-deferred.
Vanguard shows you all of their retirement accounts available to small business owners.
What Are You Waiting For?
Remember, taxes and interest are to be legally avoided whenever possible. Doing so is like a cheat code to building wealth fast. We’ve shown you how to avoid interest on student loans, credit cards, and your mortgage.
Now we’ve shown you how to avoid taxes by starting your own business. Start now; just a few hours a week could not only start bringing in money but save you a fortune on taxes too.
Legal Zoom can do all the heavy lifting of creating your business and show you the benefits of an LLC vs. S Corp.
Disclaimer: We are not tax advisors, and you should consult with one before you start deducting things like crazy and stuff like that – both Thomas and Andrew do.
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