As you prepare to start a business, it’s important to have your legal and financial responsibilities in order. Forming an LLC comes with the primary benefit of personal liability protection. Taking that one step further by operating as an S corp may come with tax benefits—in exchange for extra regulations and restrictions on how the company can be managed. In this article we'll explore what LLC and S-Corp are and what the key differences are.
What is an LLC?
An LLC is a type of legal entity that can be formed by either an individual as a single-member LLC or by a group of owners as a multi-member LLC. One of the primary benefits of choosing this business structure is that it typically protects the owner’s personal assets from business-related lawsuits and debt collection. The formation process is still relatively simple and inexpensive, making it an attainable option for sole proprietors or start-ups who want that extra layer of protection.
In order to form an LLC, applicants must apply through their state. The process may look a little different depending on where you live, but it usually requires just a bit of paperwork and a fee, which is typically less than $1,000. You’ll also need to apply for an employer identification number (EIN) through the IRS.
An LLC is a type of pass-through entity, which offers some flexibility for tax purposes. Rather than being taxed at the corporate tax rate, company profits pass through to the owner’s personal income taxes. In most cases, you also have to pay self-employment taxes on the income. There are a few different tax classifications available to LLCs, which is how you can have an LLC that elects to be taxed as an S corporation.
What is an S corp?
S corporation, or S corp, is short for “Subchapter S corporation.” This refers to a section in the US Internal Revenue Service’s Internal Revenue Code chapter that legally permits certain corporations to pass corporate income and losses through to shareholders. An S corp is also a type of legal entity for forming and operating a business.
In order to qualify as an S corp, your LLC must be based in the US, be governed by a board of directors, and have no more than 100 shareholders. It’s also OK to have a single shareholder and a single member for the board of directors. However, it can not have any corporations, partnerships, or non-resident aliens as shareholders.
Additionally, an S corp may have only one class of stock: common stock or preferred stock. The difference between the two is how shareholders receive dividends. With a common stock, shareholders receive a dividend when the LLC has profits. With preferred stock, there’s a fixed dividend for shareholders. (Note: C corps can issue both types of stock.)
Being taxed as an S corp comes with tax benefits for owners because it allows them to have two types of compensation: salary and distributions. Salaries are subject to payroll tax, which funds Social Security and Medicare. Distributions are subject only to the owner’s income tax.
Note that not all states and even cities recognize S corp’s pass-through taxation. For example, New York City assesses a corporate tax on S corps. If you’re considering forming or converting to an S corp, make sure to research state-specific requirements or policies.
Key Difference Between LLC vs. S corp
LLCs and S corps have several differences in formation, administration, and taxation processes. LLCs that elect to be taxed as an S corp must follow S corp processes.
There are two separate processes for forming an LLC versus an S corp. The following steps are required to start a business as an LLC:
- File articles of organization with your state.
- Create an operating agreement that outlines the ownership structure of the LLC.
- Choose a registered agent who is responsible for receiving any communication to the LLC.
- Register for a state and/or local business license.
The final step of creating an LLC is to choose the company’s tax status when you apply for an EIN with the IRS. To choose the S corp status, you must file IRS Form 2553, which confirms your eligibility based on the number of shareholders—there must be at least one and no more than 100.
Additionally, the business must follow operating protocols to maintain S corp status. The business must hold regularly scheduled meetings of directors and shareholders. Minutes of those meetings must be recorded per the company bylaws.
The state in which you incorporate may also charge an annual filing fee for S corps. Check on your state’s business site to determine whether or not you must file and pay a fee each year.
Owners of S corps—if they actively work for the company—must be compensated with a “reasonable” W2 salary, paid via payroll. Company profits beyond that salary income may be taken as distributions. LLC owners are not required to be compensated via salary; rather, they can take all business income as pass-through income.
There are major differences in taxation when comparing an LLC to an S corp. An LLC with no special tax election is taxed either as a sole proprietorship or a partnership, depending on the number of owners. Either way, the business’ profits are passed through to the owner(s). Instead of paying corporate taxes, the owner pays income tax as well as self-employment tax, which covers Social Security and Medicare contributions. In 2021, the self-employment tax rate was 15.3%.
Choosing to be taxed as an S corp can help to reduce the amount of self-employment tax you must pay. That’s because the owner’s salary is subject to payroll taxes and income taxes, but all company profits beyond that can be taken as distributions, which are taxed as ordinary income. Self-employment taxes do not apply to distributions.
Another difference between operating as an LLC and an S corp is how ownership can be structured. There’s no limit to how many members (or owners) an LLC may have. But once you choose an S corp election, the LLC may have no more than 100 members.
This may not be an issue for solopreneurs or small business owners, but should be kept in mind if you intend to scale the business or need outside investment. S corp owners must also share the same type of stock; shares can’t be split between common and preferred. Finally, an S corp must have a board of directors and officers. Solopreneurs can simply fill this role themselves, but the process does add a level of complexity when there are multiple owners.
It’s simple to start an LLC; you need articles of organization and an operating agreement to file with the state. But you’ll need some additional documents in order to operate as an S corp as well, including:
- Corporate bylaws
- Minutes from annual shareholder meetings
- Minutes from annual board of directors meeting
It can be helpful to get external assistance if you’re unsure of the proper procedures for recordkeeping. A tax adviser with experience in small business is a great starting point for determining all of the correct steps to take with your state and the IRS.
For some LLCs, there may be tax benefits to enjoy by choosing to be taxed as an S corp. There are multiple legal steps that need to be taken in order to stay in compliance with both federal and state regulations. But the extra effort may well be worth it if you can lower your overall tax liability.