Making money blogging is the goal. And, when the money starts to roll in, it can be exciting! After all, you’ve created an income out of nothing. Good for you! But then, you realize you forgot to consider one crucial aspect…..taxes.
Nobody likes to pay taxes. None of us wants to give the government any more money than we must, right? That is a reason many bloggers consider the LLC. But, is that what you need to even consider when it comes to your tax situation?
There is a lot of advice out there when it comes to LLCs. Some of it useful…some not so much. When it comes to discussing taxes and related issues, you need to know the person who is addressing your questions knows what they are talking about.
I’ve invited Eric Nisall to write an article to help address some of your burning LLC questions. Keep in mind that this is informational only, and this post should not be construed to be legal or accounting advice of any kind. You need to seek out the help of your professional when it comes to whether you need an LLC or not.
Hey everyone, I’m Eric!
I’m an accountant specializing in online businesses such as freelancers and bloggers and a small business expert.
You may have read my article here in which I answered questions directly from readers about accounting for their blogging business (that’s the link so head on over if you have any questions as they might just be answered there 😎).
Here, I’m going to address some of the information and a lot of misinformation surrounding LLCs and S Corporations.
You see, there are a lot of people out there–on blogs or Facebook groups–who like to give “advice” when they have no business doing so. Some people think that if they do a task one time, that makes them an “expert” qualified to advise others.
Or, you have people that take their personal situation and project it onto everyone else, like “it worked for me so it will work for you.”
I’m going to say this a lot probably–Please, please, please always take advice from people online with a giant grain of salt and always seek out the advice of a qualified professional!
When Is The Right Time To for Bloggers “Incorporate?”
First, let me state that the term “incorporate” is used to refer to the act of officially forming a business, ie, Single-Member LLC, Partnership Corporation, etc.
Next, let’s clear the air about something:
HOW MUCH THE BUSINESS MAKES HAS NOTHING TO DO WITH THE DECISION TO INCORPORATE OR NOT!
It doesn’t matter if you are losing $10k or profiting $100k, LLCs and Corporations of all kinds are legal matter entities. What that means is they are regulated by the individual states, not the IRS, which is why you don’t go to the IRS to form one.
The primary purpose is legal protection for the members/shareholders–separating personal and business assets.
Another primary concern would be ownership in the future.
- Will you take on partners or investors?
- Will you want to sell at some point?
So, when someone asks, “When should I think about forming an LLC?” I say one thing:
Speak to an attorney, they will give you the best guidance as far as which business structure will be best for your purposes and future needs.
Eric J. Nisall
If you want to decide on your own, then you should do it if you have any assets in your name–period. When that decision is made, then you speak to your accountant about ways to get tax benefits from making certain tax elections, such as opting to be treated as an S Corporation.
In and of itself, a Single-Member LLC provides no tax benefits over a sole proprietorship as they are treated exactly the same by the IRS, which shows you that it’s strictly a state-based, legally-driven decision.
Sometimes you’ll hear people talking about becoming an S Corporation to get tax advantages, so if let’s talk about that now…
What’s an S Corporation?
An S Corporation is something in name only. You won’t find any state in which you can form an S Corporation right off the bat.
It’s accomplished by filing a Form 2553 Election by a Small Business Corporation with the IRS. Then, depending on the state in which you have formed the business, you may have to file some additional paperwork with the state to gain the designation there as well.
So what is it exactly?
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Internal Revenue Service
It’s an entity that is legally separate from the shareholders, but for federal tax purposes, it doesn’t pay its own taxes. Instead, the net operating income, interest income, and capital gains, etc. are passed to the owners based on their ownership percentage, and they report those figures on their personal income tax returns.
The S Corporation must follow strict rules to be approved and to continue operating as such. The Business in question must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
No foreign investors. No preferred stocks or Class A, B, C, etc. No businesses as shareholders.
Those are the basics of the S Corporation, but I’m pretty sure you are waiting for the part about saving money of self-employment taxes, so many people brag about on social media.
Self-Employment Tax Savings With An S-Corp
Here we go! This is the part that gets people foaming at the mouth about saving on the 15.3% for self-employment taxes!
When you elect to be treated as an S Corp, as the shareholder-employee, you are required to take a salary which includes self-employment taxes (social security and medicare paid by the employer and matched by the employer).
You are also supposed to distribute the net profits (pass-through income) of the business to all shareholders based on their ownership ratio, which are only taxed at the shareholder’s individual tax rate, and doesn’t have self-employment taxes attached.
That second part is where the so-called “tax savings” comes from and what gets people geeked: they can take a smaller salary and not have to pay self-employment taxes on this pass-through income.
The IRS has some guidelines about salary, but it isn’t very precise. Some of the things that you need to keep in mind when coming up with a wage are:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
There is, however, a problem here. It leaves open to interpretation what a proper salary should be. Some people suggest searching what your primary “skill” in the business pays in your city.
For example, if you are a freelance writer, they say to go to one of those employment websites and see what that profession get paid where you live. If you do many tasks throughout the day, some people suggest you track your time and pay yourself based on the rates for each task.
It gets complicated.
Many accountants have adopted the so-called 60/40 rule for determining officer compensation. This is a simple calculation that says that you should take 60% of your income from salary and 40% from the net profit distributions; this way, you can show the IRS a clear distinction between the two and not trying to avoid paying self-employment taxes.
This makes it easier to figure out what a “reasonable” salary should be for those who are the business–meaning that if you take the shareholder-employee out of the picture, there is no business. It’s different if you are the shareholder-employee but hire people to do literally everything and you only spend a few hours a week checking in.
In that case, it’s perfectly reasonable to give yourself the salary of an office manager or something similar and not worry about the IRS.
Why am I mentioning all of this about reasonableness?
The IRS actually does look at these things and had changed the returns for people in the past who were determined to have been avoiding self-employment taxes by taking all of their money from the business as distributions or dividends.
Things You Don’t Hear About S Corps
I hate when people throw out the blanket advice that everyone should do the S Corporation election. It’s just pure garbage “advice.”
Can it help some people?
Is it for everyone?
The S Corp election isn’t only about tax savings. Let’s look at some reasons you wouldn’t want to go the S Corp election route, and some non-tax reasons why you would.
You Want To Maximize All Retirement Saving Options
If you are like many people, you want to make sure you are saving as much as possible for retirement. You max out your 401(k) and contribute to an HSA, and have an individual IRA, etc.
So why would you want to cut off your nose to spite your face?
Social Security is another income stream in retirement.
Not paying in now only means that you will be getting less once you qualify to receive Social Security benefits. If you were genuinely interested in maximizing every retirement savings option, you would want to take payroll up to the Social security limit each year.
Making Too Much Negates Self-Employment Tax Savings
Let’s say your business makes $300k a year net profit. Even if we take a 50% salary that puts your salary at $150k.
The Social Security cap is $137,700, which means you only pay Social Security tax on that amount. Anything in excess is automatically exempt from that particular tax.
If you did the simple math, you’d come up with a tax savings of $22,950: $150,000 of distributions not taxed for SS & Medicare x 15.3%, which is the combined rate for employee plus employer. But because you already reached the cap on your salary, that is a false equation.
The real savings would be $4,350, which is the Medicare tax that is saved on the distribution since Medicare has no cap and is taxed on all wages.
Again, this is because you made so much money that even if you put more into salary, every additional dollar would be exempt from the SS taxes; it would only be taxed for Medicare at that point.
So there goes the majority of the so-called S Corporation self-employment tax savings. Sure, you are still saving on the Medicare tax, but that’s at 2.9% for employer + employee vs. the 15.3% savings everyone throws out there!
S Corps Come With More Costs
It’s easy to make the election to be treated as an S Corp for tax purposes. That doesn’t mean it’s easy to manage once the election is made.
We already covered the fact that you will need to take a salary when you make the S Corp election.
How are you going to handle the payroll:
- Calculating the payroll taxes
- Issuing the paychecks
- Submitting all of the withholding taxes
- Filing the payroll tax returns (quarterly and annually)
Personally, I use a service for my small business payroll needs. All of my clients that are S Corps do too.
But it costs money.
Then you have Unemployment Compensation Tax for the state and federal governments (SUTA and FUTA, respectively). Don’t forget the possibility of State Disability Insurance (SBI) or Family Medical Leave Insurance (FMLI) that you may not be able to opt-out of depending on your specific state and business.
Oh, and don’t forget about paying for an entire set of tax returns–yup, an S Corp has to file its own federal income tax return and possible state return as well.
That’s going to cost you extra too. The self-employment tax savings are going to get eaten into by all of these administrative costs.
Some people will go ahead even if they can save $1. Others view it as too much to deal with to save whatever they will–I’ve had people pass up $2k in net savings after the potential additional taxes & fees because it wasn’t worth it to them to deal with all of the admin stuff.
You need to decide for yourself!
Having Pay Stubs & W-2 Makes Life Easier
In case you don’t already know, being self-employed and getting financing or showing proof of income for a rental can be an arduous task. You need to show months upon months upon banks statement for both your business and personal accounts, as well as a few years of tax returns.
When you are “employed,” it’s often easier, because you have less paperwork. Show a W-2, a tax return, and a couple of your last pay stubs, and that’s pretty much it.
It’s also easier to budget when you have the structure of being on payroll. Instead of taking business money for personal expenses multiple times a month, you have your regular twice-monthly paycheck just like you did when you were an employee for someone else.
Some people view that structure as enough of a reason to go the S Corp route. Again, most of the time, you are only going to be told about the self-employment tax savings and present the entire picture for your consideration.
C Corporations & The Qualified Business Income (QBI) Deduction
Have you ever heard about QBI? Most people haven’t. I’m going to be honest, it’s a very convoluted and difficult topic to discuss, and I’m not going to attempt to do so in-depth.
It’s a new rule which took effect for the 2018 tax year, which complicates matters exponentially.
There are deductions for pass-through businesses such as sole proprietorships, partnerships & S corporations (but NOT C Corporations).
Sometimes the deduction is 20% of Qualified Business Income. Sometimes it’s 50% of wages paid by your S Corporation.
There are income limitations that reduce the deduction based on filing status as well as the type of business you run.
If I’m being transparent (and I always am), I can’t even find the words to explain it without creating an entire article dedicated solely to this one topic.
Then you have the option to be a regular C Corporation. This type of business doesn’t have the limits the S Corporation does on ownership.
It also pays its own taxes, not passing the income through to the owners to pay on their individual tax returns. The “distributions” from a C Corporation are called Dividends and are taxed at special rates, which can be lower than the rate at which your S Corp distributions are taxed at.
Also, the C Corp maximum federal tax rates are lower than the individual max tax rates.
This all throws another wrench into the works because, in some cases, a traditional C Corporation can be better tax-wise for higher-income individuals, especially in high-income tax states.
I only mention this because it goes into the decision of what structure to and tax treatment to elect for your business. Not many smaller businesses need to worry, but there are plenty of bloggers, writers, content creators, course instructors, etc. who do make enough money for this section to make a difference.
You would be best served to try to read up on the Qualified Business Income Deduction and then to engage a qualified tax/business attorney or accountant to help make sense of all of the information.
Some people might look at all of this and think it’s an attempt to discourage you from something. It couldn’t be further from the truth.
This is meant to empower you by making sure you have all of the information available to make an informed decision. Too often, people try to sell you the dream and then leave you to face reality on your own.
How do you think I get most of my clients!?
They come to me saying things like:
Everyone was talking about the benefits of working for myself but no one ever mentioned the taxes would be so much and I wasn’t prepared
No one ever told me about having to pay state estimated taxes
So yeah, I want you to hear the full story from someone qualified to talk about rather than take half-baked advice from someone who has no business opening their mouth. And please, any time you have a question, go talk to an attorney if it’s a legal matter or an accountant if it’s a tax matter…don’t run to Facebook or your friend who is “smart about everything.”
You need to be able to take your personal financial and business life and tailor a solution to that…not take someone else’s solution, which is in a different situation than you.
What works for one person isn’t guaranteed to work for everyone, please keep that in mind when it comes to everything you read and hear on all subject matter.
Thanks to everyone for spending their time reading this, and thanks to Tracie for having back!
Hopefully, you learned something you didn’t know or confirmed something you suspected and needed verification on! 😁