Should Your Psychology Practice be an LLC or an S-CORP?

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As always, this isn’t tax or legal advice. If you have someone advising you then you probably don’t need to read this anyway, but I’m speaking only about my own experience and what has worked for me. Also, this is state dependent. For example, for those in CA there is no liability protection for LLCs.

Sole Proprietorship

This is basically a side gig. If I knitted blankets, posted them on Etsy, and packed and shipped them out of my garage, then at the end of the year I’d have to claim the sales I made on blankets and pay taxes. But if one of my blankets spontaneously caught on fire and someone sued me over it, they could come after me for all my assets – not just my yarn and needles and stock, but also my garage and my house and my car. This is a sole proprietorship. It saves you nothing in taxes, and it provides you no liability protection. But it's nice and simple, and you can start the second you finish this sentence.

LLC

What this does is place a small layer of protection between you and your business. This is called “the corporate veil.” If I had an LLC and someone sued my fire-catching blanket business, they can take my yarn and needles and stock, but not my house and car. Still, it saves you nothing in taxes, but it provides some liability protection for a couple of hundred in filing fees and a couple of headaches in paperwork. You can read how to set this up here.

S-CORP

This is essentially a filing status that saves you money on payroll taxes. It’s not necessarily a good option for people in solo practice with a small side gig because it comes with increased expenses and increased obligations, and that only starts to get worth it past a certain profit level. We’ll talk about that in a sec.

Let’s start with the obligations. As a corporation, you have to have employees. That can be you. You can be your employee. But you’re going to have to start payrolling yourself. That means you probably have to hire a company to send you a paycheck, and it can get confusing to separate you as a corporation from you as an employee. You also need to have a board meeting. It can be with yourself in Hawaii if you want, but, varying by state, you typically have to review your financials and company policies and whatnot and then document that you completed this meeting annually.

What are your tax obligations?

There are two kinds of taxes. Payroll taxes, and income taxes. Everyone pays some of both. There isn’t going to be any difference between any of these three groups for income taxes. Whether you’re a sole proprietor, LLC, or S-CORP, if your business makes 100k after expenses, then you’re going to pay income taxes on 100k in any of these categories.

So the tax differences in these categories is only about payroll taxes. With an S-CORP, you only pay payroll taxes on the paycheck. So you were paid 60k in salary, you pay 7.65% of that in payroll taxes, (and the business pays the other 7.65%). But if your business made 100k, not 60k, then that means you’re not paying employee payroll taxes on that remaining 40k, which is called a “distribution.”

Uncertain? Let’s look at an example.  

Let’s say your business grosses 100k, with 20k in expenses. You brought home 80k. Way to go!

No matter what, you’re going to pay the same income taxes on the 80k you earned. That income determines your tax bracket, which in the example of 80k I believe would mean 22%. So you’d owe $17,600 in income taxes whether you’re an LLC or an S-CORP. (please don’t use these numbers to do your own taxes – you actually only take 92% of those earnings for tax calculations so this is only for illustrative purposes).

Let’s round your income tax down to $17k. You owe that whether you're an LLC or an S-CORP.

As an LLC, the amount the government sees as your “payroll” is all 80k. They’ll take 15% of that in self-employment taxes, which are basically both portions of these FICA taxes (again, they’re calculating 92% of it) so using broad round numbers here that’s about 11k.

As an S-CORP, the amount the government sees as your “payroll” is your paycheck. In our example let’s say you payroll yourself 60k, and you take the remaining 20k as a “distribution.”

For the paycheck part, the 60k, the government still needs their 15% but they’re going to assign half of it to your “employer.” This is what gets confusing because you are your employer. So you’re still paying 15%, practically speaking, except only on 60k, not 80k. So that’s actually only about $9300. That means that about $1700 in taxes stays in the pocket of your business. Plus, that half of payroll taxes the business pays is an expense, so that's saving you a little in income taxes too. Even though the filing will cost you more (accountants charge more for S-CORP filing than LLC filing), you’re still out ahead a good $1000-1500 that stays with your S-CORP but not your LLC.

Again, these are broad, round numbers we’re using here. But even conservatively here, an S-CORP has saved 1k just by virtue of this filing status. That starts to get into real money, and that savings only grows if you’re taking more in distributions.

So then why doesn’t everyone form an S-CORP?

It costs more to do your taxes, because it’s more complicated. So the amount you save in taxes has to offset and justify those increased costs. Some states also assign extra fees or taxes for S-CORPS that they don’t for the others, further reducing what you can save.

Also, you have to payroll yourself, which is intimidating and confusing for a lot of psychologists who aren’t trained in business and don’t know what that means. And even if you can figure out payrolling yourself, it can be annoying to start looking at your income differently in terms of what comes in from your paycheck and what comes in from your remaining profits, or distributions.

Most S-CORPs have stricter obligations like paying quarterly taxes, though depending on the income a lot of LLCs are going to have that too.

LLCs have fewer rules and obligations (no board meeting, for example), and some people just want to keep things simple.

What’s the bottom line?

The rule of thumb I’ve heard is that if you’re bringing in 80k or more in profit, the scales start to tip towards S-CORPS. That’s about when the increased complexities start to be worth the savings. But it will always come back to the difference between a reasonable salary and your remaining profits, and in mental health that can vary tremendously (because in the real world, some psychologists are salaried at 50k, and some at 150k). Basically, if you’re at or around 80k in profit, it’s worth asking your accountant (or paying for a one-off consult if you typically file on your own), whether it’s worth having your LLC file as an S-CORP.

Can you just tell me how much to set aside in taxes?

The general advice I’ve heard is that whichever of these groups you’re in, set aside 30-35% of every dollar you bring in. The actual amount you owe (payroll + income taxes) is going to be based on your deductions, your tax bracket, and then how much of your profit you’re paying payroll taxes on. The best news is when you’ve over-saved for taxes. And if you stick with this practice of saving at least 30% then you’re probably going to have some of that savings left in your pocket - this is essentially what other people usually get in a tax refund. If your business earns 100k that means putting 30k into an account over the year and not using it for anything else besides taxes – and you can see from the example we used above that even as an LLC, if you made 100k, saved 30k, and your taxes were 28k then you’d have a 2k cushion at the end of the year.