Business Structure Overview
Your business structure affects three things:
- Liability: Are personal assets protected if sued?
- Taxes: How much do you pay to federal/state?
- Complexity: How much paperwork and cost?
Most sellers start as Sole Proprietor or LLC. As you scale past $100K profit, S-Corp becomes attractive due to tax savings.
Business Structures Comparison
| Structure | Setup Cost | Annual Cost | Self-Employment Tax | Liability Protection |
|---|---|---|---|---|
| Sole Proprietor | $0 | $0 | 15.3% on all profit | None (personal liable) |
| LLC | $100-300 | $0-800/year | 15.3% on all profit (same as sole prop) | ✓ Personal assets protected |
| S-Corp (LLC electing S) | $100-300 (LLC) + $600+ (S election + accountant) | $1,500-3,000/year | 15.3% on salary only (reduced on distributions) | ✓ Personal assets protected |
| C-Corp | $300-500 | $2,000-5,000/year | Double taxation (corporate + personal) | ✓ Personal assets protected |
LLC vs S-Corp Deep Dive
LLC Advantages
- Simple setup: File articles of organization with state ($100-300)
- Liability protection: Personal assets protected if sued
- Flexible taxes: Can be taxed as sole prop, partnership, or S-Corp
- Low cost: Annual costs typically $0-800 (varies by state)
- Professional image: Better for loan applications, contracts
LLC Disadvantages
- Self-employment tax: Pay 15.3% on all net profit (expensive at $100K+)
- State complexity: Some states require annual reports, fees
- Not optimized for high profit: Tax bill grows with profit
When to Use LLC
Best for sellers with:
- Under $100K annual profit
- Want simplicity and low cost
- Not ready to optimize taxes yet
S-Corp Advantages
- Tax savings: Can save $5,000-20,000+/year on self-employment taxes
- Pay yourself salary: Salary taxed as W-2 income (15.3% SE tax)
- Profit distributions: Remaining profit bypasses SE tax (15.3% savings)
- Liability protection: Personal assets protected (LLC + S election)
S-Corp Disadvantages
- More complex: Requires separate tax filing (Form 1120-S)
- More expensive: Accountant fees $1,500-3,000/year
- Payroll requirements: Must pay yourself reasonable salary
- More paperwork: Quarterly payroll filings, W-2 preparation
- State taxes: Some states have S-Corp entity-level taxes
When to Use S-Corp
Best for sellers with:
- $80,000+ annual profit
- Tax savings exceed accounting costs
- Want to optimize after-tax profit
Real Example: Tax Savings with S-Corp
Scenario: Seller with $150,000 net profit
LLC (No S Election):
Self-employment tax: $150,000 × 15.3% = $22,950
Income tax (24% bracket): $150,000 × 24% = $36,000
Total tax: $58,950
S-Corp (LLC with S Election):
Salary: $100,000 (reasonable for your role)
Profit distribution: $50,000
Payroll taxes on salary: $100,000 × 15.3% = $15,300
Income tax (combined): $150,000 × 24% = $36,000
Total tax: $51,300
Tax savings: $58,950 - $51,300 = $7,650/year
Minus accountant cost ($2,000): Net savings: $5,650/year
How to Convert to S-Corp
Step 1: Create an LLC (If You Don't Have One)
- File articles of organization with your state
- Cost: $100-300
- Time: 1 week to approval
Step 2: Get an EIN
- Apply for Employer Identification Number at IRS.gov
- Cost: Free
- Time: Instant online
Step 3: File Form 2553 (S-Corp Election)
- File Form 2553 with the IRS
- Deadline: Within 2 months and 15 days of start of tax year
- Best done with accountant
- Cost: $500-1,000 (accountant fee to prepare)
Step 4: Set Up Payroll
- Use ADP, Gusto, or Paychex for payroll
- Pay yourself W-2 salary (quarterly or monthly)
- Cost: $100-300/month for payroll processing
Total Conversion Cost
- LLC formation: $150-300
- S-Corp election (accountant): $500-1,000
- Annual accounting/payroll: $2,000-3,000
- Break-even point: $80,000+ annual profit
IRS Red Flags for S-Corp
The IRS watches S-Corps closely. Key risk area:
- Unreasonably low salary: If paying yourself $30K but taking $120K distributions, IRS will reclassify as salary (subject to SE tax)
- No W-2 at all: If paying all as distributions, audit likely
- Salary too high: If paying $150K salary on $150K profit (no distributions), you're paying extra payroll taxes
What's "Reasonable" Salary?
- Generally 50-60% of net profit is reasonable salary
- Example: $150K profit = $75K-90K reasonable salary
- Rest ($60K-75K) taken as distributions (no SE tax)
- Work with accountant to document reasonableness
Summary: LLC vs S-Corp Decision
Choose LLC if: Under $80K profit, want simplicity
Choose S-Corp if: Over $80K profit, want to minimize taxes
Process: Start as LLC, elect S-Corp when profit threshold reached
Timing: Most sellers convert in year 2-3 when profits grow