So, your side hustle is making actual money. More than just “buy a fancy coffee” money — we’re talking “this could actually be a thing” money. Congratulations! Now comes the fun part: explaining to the government how you’re doing it.
The IRS gives you options, and like most things in life, each comes with its own special blend of benefits and headaches.
But for most small businesses, the choice of how to structure your business boils down to a single question: Are you making enough money yet to justify the extra paperwork?
The Lineup: Your Three Main Options
- Sole Proprietorship: If you start doing business but don’t register as anything else, you’re a sole proprietor. It’s wonderfully simple, but there is zero liability protection. If your business gets sued, your personal assets (house, car, savings) are on the line. You just file a Schedule C with your individual tax return and call it a day.
- LLC (Limited Liability Company): The whole point of an LLC is that it protects your personal assets from business debts and lawsuits. But for tax purposes, a single-member LLC is treated exactly like a sole proprietorship by default. You get the same simple tax filing, but with a legal wall protecting your personal stuff.
- S-Corp: This is where everyone gets confused. An S-Corp isn’t a business structure; it’s a tax election. Both LLCs and corporations can ask the IRS to be taxed as an S-Corp. The magic here is the potential for significant tax savings, but the price is a whole lot more complexity.
A sole prop is casual Friday. An LLC is casual Friday with a protective blazer. An S-Corp is a whole business formal with a tie that’s always just a little too tight.
The Self-Employment Tax Bomb (All About the 15.3%)
Here’s why this matters. As a sole prop or default LLC, you have to pay a 15.3% self-employment tax on every single dollar of your net business income.
If your business profits are $100,000, that’s a whopping $15,300 in self-employment tax alone, before you even touch income tax.
The S-Corp offers a clever and perfectly legal way around this. You split your income into two categories:
- A Reasonable Salary (which is subject to that 15.3% tax)
- Distributions from profits (which are not subject to self-employment tax)
On that same $100,000 profit, you might pay yourself a $60,000 salary and take the other $40,000 as a distribution. You just saved yourself over $6,000 in taxes.
The “Reasonable Salary” Rule (Don’t Get Cute)
Now, before you decide to pay yourself a salary of $1, hold on. The IRS has a significant rule: you must pay yourself “reasonable compensation.”
This means a salary that someone with similar experience in your industry would typically earn. If you guess wrong, the IRS can reclassify your distributions as wages and send you a bill for all the back taxes, plus penalties. Ouch.
Which One is Right for You?
It mostly comes down to profit and risk.
- Under $50k profit? Stick with a sole prop, or get an LLC if you’re worried about liability. Don’t overthink it.
- $50k – $80k profit? An LLC is a great choice. Start running the numbers to see if an S-Corp makes sense yet.
- $80k+ profit? Seriously consider electing S-Corp status. The tax savings become very real at this level.
The Hidden Costs of an S-Corp
These tax savings aren’t free. Remember to factor in the extra costs:
- Payroll Service: You have to run a formal payroll for yourself.
- Separate Tax Return: You have to file a separate business return (Form 1120-S) by March 15th.
- Accounting Fees: This is not DIY territory. You will need a CPA.
Always calculate your potential tax savings after subtracting these very real costs.
Remember, you can change your structure as you grow. Start simple and upgrade when it makes clear financial sense. An LLC is a fantastic tool for most small businesses, and the S-Corp is a powerful way to save on taxes once your profits are high enough.
Now go forth and structure wisely.
