- Hey guys, Toby Mathis here and today we're going to
go into the difference between an S corporation and an LLC. Seem to get that question all the time. So we're going to dive straight on in. First off, we're going to have
to make sure that we understand and we're using the same language. So I'm going to share a screen out. So I'm going to make three columns. 1, 2, 3, and those columns, I'm going to label the state, the IRS and third parties. Oh. I butchered that one, parties. All right, why are we breaking
this into three categories? 'Cause you got to understand
that when we say LLC versus S corp, it's actually
kind of a false dichotomy because an LLC can be an S corp and I'll make that make
sense here in a second. First off, the state,
you are paying it money for protections and those protections
take the form of entities. So for example, you could
have a limited partnership, you could have a corporation, pen like, giving me a little trouble here. You could have a corporation, you could have a LLC, which is equal to limited liability company. And what the state is doing is giving you certain protections. You'll notice I didn't
say S corp or C corp or nonprofit or if you know, we start
getting into the weeds here. The state has very broad categories and what they're doing is
you are paying them money and they are giving you protection. And this is how it works. Let's say that you set up an entity, let's say this is an LLC
and it is doing a business and there's a liability in that business and they try to come out here and get to you, it's going
to ricochet right back in. It's going to stay within
the walls of that company. It's going to bounce around
there, the liability. So let's say that you're a plumber and you flood somebody's house, you do something wrong
on a job or something. You forget, one of your workers
forgets to attach a pipe. Actually had this happen
to one of my houses. So I can actually say,
and it floods, okay? Your liability, if you
get sued, is limited to your business, they're not
going to come take all your personal assets if you have
the protection of an entity. That's why people set up
these little LLCs all the time because they provide a ton of protection. This has nothing to do with taxes. An LLC could be whatever it wants to be, as far as the IRS concerned. In fact, there is no tax form for an LLC. You have to tell the IRS
how you want it to be taxed. Hate it when the pen
doesn't get me, all right. So from a IRS standpoint,
let me just go through what our options are 'cause we have individuals,
where you're filing a 1040. You have partnerships, where you're filing a 1065, you have C corporations, this is what all corporations start off as and they start off as what's called 1120. Then you have S corporation, which is when you file a special request to treat it under a different chapter of the Internal Revenue
Service, a subchapter. And that's why they call
'em S, they're subchapter S. So people will generally call
a plain vanilla corporation a C corp and an S corp,
they'll call it an S corp. Corporations, just so you know, they're taxed at 21% on their net income, on their profit. S corporations, it flows
down to the shareholders. Everything else here flows
down to the shareholders. Now there are exempt organizations that we're all familiar with. IRAs, 401k, 457s, even 501s. You guys are probably
familiar with 501 (c)(3)s, but 501s are exempt. And then you have trusts, which file this 1041. Why is this relevant to the
whole comment between a LLC versus an S corp because that LLC can be an S
corp, it could be a C corp, it could be a partnership,
it could be you. In fact, 99% of the time when I see folks that are comparing an
LLC versus an S corp, what they're really comparing
is themselves as a business versus their LLC taxes, a corporation generally an S corp. So I'll go over that here in a second. They could be exempt, they could be an LLC that is taxed as a trust. Yes, some of you guys just said, oh no, corporations are the only
type, you could technically, you could set up an LLC and
get it exempt under 501 (c)(3). You could also have an LLC that is, the member is an IRA or
the member is a 401k. So it's taxed on those tax forms. IRA, 401ks, you're talking about 5500s, 501 (c)(3)s, 501s, private foundations, all these things are on 990. So there's different types
of tax forms for everything. But the IRS doesn't really care
what you did with the state. They just say how do you want to tax it? How do you want us to look at it? What tax form is it going to go onto? So if you make $100,000, we know where it's going to
land so we can track it. That's all they care about. They want to get paid. Third parties. Now who are we talking about when we're talking about third parties? We are talking about, quite
often we're talking about banks, lenders, investors, municipalities, you know, for business licensing
and things like that. What they're going to want
to see is your agreement, your body and your body, if it's an LLC, is called an operating agreement. You never want to leave
these things to chance. You got to document. This is the rights of, in an LLC, the owners are called members. The managers are called
managers, believe it or not. So you have to choose whether
you're going to be managed by your members or your managers. We're almost always using managers, but it's going to say, who has
the right to manage the company? What are the rules that
they're operating under? You understand now why a
bank might want to know that 'cause hey, I'm setting up a bank account. Who can access it? How much? Can they just drain the account? Can they buy whatever they want? They want to see that operating
agreement so they know kind of the parameters that
they have around the folks that they're engaging with,
that they have authority to bind that LLC. 'Cause remember, we have asset protection. This whole thing right here, the banks and lenders and everybody else, even other businesses, they want to know like, we
could put that up there. Other businesses, they want
to know, you have the right to engage in this transaction 'cause if they sue the business, they know that they're going to be limited
in what they can get back. So they're going to be limited
to what's inside that business. If they're not comfortable
with that business, what they might do is
they might come to you and say, "Hey, I understand
that you want this loan or you're going to do this transaction. But I want a guarantee, and I want one of the members to guarantee a personal guarantor." And I'm certain that a lot
of you guys in real estate have had to deal with that because they don't want to
be stuck inside the box. They want to know that if, hey,
if I end up looking at loss, like I don't know what you're
going to do with the property if I loan on it, if you destroy
the property, I still want to be able to look at somebody else. So that's always a negotiating point. When you are a corporation, they use something called bylaws. That's the same thing. We created a body. So now we know what the
rules are that cover that. Now people always say
like, what's the difference between an LLC and an S corp? Well nomenclature, right? They call, an LLC will
call its people members. A corporation, a plain vanilla corporation like you set it up under
the state, has shareholders. But guess what? I could be an LLC, I could be this taxed as an S corp and I still have members, even though they're shareholders, right? IRS is considering them shareholders, but from a state standpoint,
I'm calling 'em members. They're basically synonymous. There's one case when you're dealing with stock loss on a
privately held company where it makes a difference between being an an LLC
proper versus an S corp or a corporation proper versus an LLC. Other than that, they're almost identical. And so that gets us out
of, when we're dealing with third parties. But that's not the calling of this, right? When I hear people say,
what's the difference between an LLC and an S corporation? What they're really doing is
they're getting over here into the tax world and they're
saying, what's the difference between these things
from a tax perspective? And I'm just going to do it like this. I'm going to say, remember
we started with the state. Let's just do a state level and
we're going to do a comparison. I am an LLC versus an S corp, but we now know that an LLC can be taxed as an S corp. So I'm going to say LLC, taxed as S corp. So we're literally changing
our story from an LLC versus an S corp to an LLC versus
anything taxed as an S corp. So it could be an S corp or
an LLC, taxed as an S corp. And from the state
standpoint it's either an LLC or it's an S corp or LLC. We're just taxing that LLC as an S corp. From the IRS standpoint,
we're doing a comparison. This LLC is going to flow onto your, it's called a sole proprietor, and it's going to go on to your 1040. If you are have an LLC taxed as an S corp or an S corp proper, it's
going to go on to an 1120-S. So you're boom, they're both going onto separate tax returns. This is going on a Schedule C, but here's where it
gets really interesting. S corporations, their net income and their losses flow on to the owners or the shareholders tax
return, they flow down to those owners. So if this is you, it's literally
going to end up on your 1040 'cause this is going to
create what's called a K-1, which is a, it's going to file as tax. You trying to say here's the owner, who this is their portion of the income. If it's just you, it's going to be a 100% and it's going to end up
being on your Schedule E. That's the difference, from
a tax forum standpoint, they both end up on your 1040. And that's really important to understand. Again, people seem to think
that these S corporations, there's some sort of mystical beast and that somehow it's not
affecting their personal tax. No, it does, but I'll show
you what it, you know, how it benefits you. In both cases, the net income, loss ends up on the return, in both cases, the net income or loss ends up on your 1040. They're very similar in that matter. That's why there's such a misunderstanding 'cause they're very, very close. But the treatment of that income is very different. And the reason being is because 100% of of net income is subject to ordinary tax and social security when you are a sole proprietor. Ordinary tax is your normal tax return. You have state taxes too. But from a federal standpoint,
we're just comparing this. Social security is 15.3%. So it's old age disability and survivors and Medicare, there's a phase that out when you get above 160,000, there's a phase back in when
you get back up over 240. So like there's, it varies, but I'm just going to
say for our purposes, let's just say regular business, you're probably talking
about 100, 150,000. It's just, these are the numbers. When you are a S corp, only wages are subject to social security. And that is because you are not an employee of your sole proprietor, but you are an employee of an escort. You cannot be an employee of
your own sole proprietorship. And that means there's
some tax differences. The biggest one is, in
this particular case, 100% of your net is going to be
subject to social security tax. Whereas realistically, only about 70% of net is going to flow down as profit and it does not get hit
with social security. Put another way, on
average, only about 30% of income, which will be made into wages, is equal to social security. Let me just spell that out for you. You make $100,000 as a sole proprietor, you
are going to pay roughly that 15.3%. There's a slight deduction
for a portion of it. So it ends up being 14.1%
when you do the math. So you're going to pay
$14,100 in employment taxes. You're going to pay tax,
your federal income tax on the remainder of the money
that flows down as well. So like, you're going to have $100,000 of taxable income that hits you. And I'm just using this as an example. People that have S corps know
that there's more deductions that you get as an S corp. I'm going to go over
that in just a second, but I'm just, I just want
to illustrate this point. So if we take a wage, let's say that we paid $30,000 in wages. Let me just do the math
on that real quick. So if we have $30,000
that we'd take as a wage, we're going to pay $4,230 in employment taxes versus 14,000. So the net difference is a positive $9,870 per year by doing that S corp. And again, S corps or
LLC, taxed as an S corp. You could literally take
this that you are doing now as a sole proprietor. And we could we could make an S selection, you could make a late
S selection, actually. You could do it at the end of the year if you really wanted to. You could even do it when
you do the tax return. There's ways to fix it. But at the end of the day, you're looking at this going shoot, there's a big difference
from a tax standpoint, but it gets better because employees get something called an accountable plan, which equals 100% of things like cell phones, computers. You could do something called 280A and write off your
house as a meeting room, up to 14 times a year. You could do an administrative
office in your home, which means a much larger deduction than like, the home office. And I'm just going to
explain it like this. If I am a sole proprietor,
I only get a percentage of the free stuff. And when I say free stuff,
I just mean tax deductible. So if I have a cell phone here and I am a sole proprietor,
I have to track what portion of my time that I'm using as business versus personal and I can
write off the business. When I do an accountable
plan and I'm an employee and my employer says, "I want
you to have a cell phone, you need to have a cell phone." It's 100% that they're writing off. So there's a huge difference. So there's a myriad of tax benefits, which means that on a typical year, it's over $10,000 difference on $100,000. And an extra 10% of profit,
which some of you guys, that's doubling your
profit, maybe tripling it, maybe all your profit, just because we're changing
the way that it's designated and you know, changing the treatment. Now there's a lot of other
tricks that you can use and lots of other benefits that
come along with knowing how to run your business, right? And running it from a tax
perspective, running it correctly. I'm not going to get into all those today. I'm just going to say that
from a 10,000 foot view, you have a pretty good idea
of the difference now between an LLC and an S corp. And you can see why there's a lot of confusion when people are asking it because guys like me
are looking at it going, an LLC versus an S corp. Well, an LLC could be an S corp. So really what we should be asking is a sole proprietor versus an S corp. And when we break that
down, it's not even close. And by the way, S corporations
get audited a fraction of the time that the sole
proprietorships get audited. It's about 800% more often
that they get audited as a sole proprietor. And then according to the last
data book I saw 17B, I think it was 2000, and they discontinued it. They used to track the audit rate and the success of those audit
rates for sole proprietors. And it was about a 94 to 95% of the time the sole
proprietorships lost their audits for the reasons that I just laid out 'cause they're supposed to be
tracking all their personal use of all their assets and nobody does. Let's just be real, most
people do not track that. It's hard enough to get
people to track their miles and there's mileage and there's apps that'll
do it for you, right? And we still have a lot of folks that just won't track their miles. They try to write off their automobiles and do all these these things. Then all you got to do is, you know, is think realistically and you're like, okay, I don't want to make my clients jump
through those hoops. I want to make it as
simple as possible for them and make sure they're
getting the biggest benefit. And 99% of the time you're
going to fall on the same way that I do, which is it's going
to be something other than a sole proprietorship. S corporation is the usual
suspect as far as the, for most practitioners, most
accountants, good accountants, they're almost always going
straight to that S corp. Especially if you're
living out of the entity 'cause you want to have
access to those dollars, they're just a lot easier to use. There's a lot more benefit. And the only complexity that
you're going to have to deal with is having to go through
payroll and taking a wage out. You could do that once a year, by the way. You could do it quarterly,
you could do it monthly if you want, but you're taking
out some sort of payroll. Usually about a third of
the net income is about what the courts have always decided, but it's technically,
it's a reasonable amount. So you're in charge of that. What I've seen, it's
usually about a third, usually about 30%. So we just use that as a starting point. But at the end of the day,
you want to be talking to your practitioner on that one. So hopefully you learned something today. If you know anybody that
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somebody about whether or not it makes sense for you to be an S corp versus just
being a sole proprietor, so you can make your LLC into an S corp. Or if you're just operating
as a sole proprietor and you want to get started, type in the word strategy
down in the comments. Just write in strategy and somebody will send you a link so you can get a free consultation to see whether it makes sense.
