US Individual income tax return. Accountant working with US tax forms
I tend to think there are way too many acronyms. If I could take an ax to all of them and cut them down, I would. But, alas, I don’t have that kind of power.
The good news is they’re not all bad. One useful one for freelancers is LLC—Limited Liability Corporation. I like this one, because I’m a huge fan of not being liable for things. It’s one of my top hobbies—the more I can limit my liability, the better.
I’m such a fan, in fact, that I started an LLC in 2021. I was told it would offer me “tax benefits,” which is one of those benefits you need to take on faith, because nobody in their right mind would ever calculate their taxes a second time under a hypothetical scenario just to see if they had saved money.
The other day, though, I was speaking to a freelancer who said her business manager was helping her set up an S Corp. I had assumed my LLC was something like birth control—a permanent life partner. But—lo and behold—I became curious. Could S Corp be the way to go?
Both are popular—there are about 5 million S Corps in the United States and 21 million LLCs. And both structures offer liability protection. However, there are some differences. If you’re as curious as I am, I’ve outlined the key distinctions.
Taxes
This is the main one. An LLC is a type of legal entity, while an S Corp is a particular type of tax status. As an S Corp owner, you are considered an employee of the company and must pay yourself a “reasonable” salary. You’re allowed to define reasonable, which is why I put it in quotes. Personally, there’s nothing reasonable about my life, especially not my salary, but that’s neither here nor there. And however reasonable it is, this salary is subject to payroll taxes such as Social Security and Medicare, and the remaining profits are taxed at a lower rate.
LLCs, on the other hand, are “pass-through entities,” which does not mean—as the name suggests—that they’re down for just “one night of fun.” Instead, their profits and losses are “passed through” to the members, who report them on their personal tax returns. LLCs are not taxed as separate entities, but some states impose an annual tax or a franchise tax on them—and they can be one of four tax statuses.
This creates large gaps in how much you can save with each. “LLCs offer no savings,” says Zhanna Kelley, CPA. “They are the same as sole proprietorships. S Corps do offer savings because they allow you to allocate net income between salary (W-2) and dividends (K-1). However, the savings vary state by state because each state has a different S Corp tax.”
Flexibility
While you might save less, LLCs offer more flexibility than S Corps. For example, LLCs can have an unlimited number of members, while S Corps are limited to 100 shareholders. I currently employ myself and sometimes my cat (she serves as Chief of Mental Health), so that’s not really an issue for me. Eighty percent of freelancers are sole proprietors, so they’re probably not bumping up the 100 person limit either, but that 20%! Could be relevant.
Furthermore, LLCs can also have a more informal management structure—you don’t need to define who handles the day-to-day business operations. S Corps, on the other hand, require a board of directors and officers. With this comes more administrative overheard when you want to make changes.
Cost
S Corps are usually more expensive to set up and maintain than LLCs, in part because of the administrative hassle. S Corps must file a separate tax return and have more complex record-keeping requirements. LLCs are generally simpler and less expensive to set up and maintain. That said, I have an LLC and it already gives me a headache—really, anything that requires me to interface with corporate law in any capacity. But as my mother always says, a small headache saves money on Advil!
Eligibility
S Corps have stricter eligibility requirements. For example, they must be a domestic corporation, only one class of stock is allowed, and there can’t be more than 100 shareholders. LLCs have no such restrictions, which I suspected. Any time I’m allowed to do anything, I generally assume anyone is allowed to do it. )I used the same spoon for breakfast, lunch, dinner, and second dinner last night. It’s insane that I technically run a company.) Anyway, LLC’s are a bit faster to set up because you don’t have to check whether or not allowed—and this can definitely save you time.
Ultimately, the decision as a freelancer to form an S Corp or an LLC depends on various factors, such as how many people work for you, how much administration you can tolerate, and how much money you make. I’m not a lawyer, so if you have more questions, you may want to check in with a tax advisor or legal professional. Good luck!
