As you prepare to start a business, it’s important to have your legal and financial responsibilities in order. Forming a limited liability company (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 the key differences between them.
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What is a limited liability company (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.
Benefits of an LCC
- Limited liability protection: LLC owners, known as members, are not personally liable for the company’s debts and liabilities. This means their personal assets, such as homes or cars, are protected from creditors.
- Tax flexibility: LLCs can choose to be taxed as a sole proprietorship, partnership, C corporation, or S corporation, allowing them to select the most favorable tax treatment.
- Ease of formation and maintenance: LLCs are generally easier to establish and maintain compared to corporations, with fewer formalities and eligibility requirements.
- Flexible management structure: LLCs can be member-managed or manager-managed, providing flexibility in how the new business is run.
Drawbacks of an LLC
- Self-employment taxes: Members of an LLC are subject to self-employment taxes, which can be higher than the taxes paid by shareholders of an S corporation.
- Limited growth potential: LLCs cannot issue stock, which may limit their ability to attract investors and grow the business.
What is an S corp?
S corporation, or S corp, is short for “Subchapter S corporation.” It’s a tax classification 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 business entity for forming and operating a business.
Benefits of an S corporation
- Limited liability protection: Like limited liability companies, S corp shareholders are not personally liable for the company’s debts and liabilities.
- Avoiding double taxation: S corps are not subject to corporate income tax. Instead, income, deductions, and credits pass through to shareholders, who report this information on their personal tax returns.
- Reduced self-employment taxes: S corp shareholders can be treated as employees, potentially reducing self-employment taxes compared to LLC members.
Drawbacks of an S corporation
- Restrictions on ownership: S corps are limited to 100 shareholders, who must be US citizens or residents. Additionally, S corps cannot be owned by other corporations or partnerships.
- Increased formalities: S corporations must follow more formalities compared to LLCs, such as holding regular shareholder and board meetings, maintaining minutes, and adhering to additional record-keeping requirements.
- Less flexibility in allocating profits and losses: Unlike LLCs, S corps are required to allocate profits and losses to shareholders in proportion to their ownership interest.
Key differences between LLC and S corps
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.
- LLC: Requires creating an operating agreement and filing articles of organization. You can choose your tax status, and must register for a state/local business license.
- S corp: Requires filing articles of incorporation and creating corporate bylaws. You must file IRS Form 2553 (S corp election) and register for a state/local business license.
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 employer identification number (EIN) with the IRS. To choose the S corp status, you must file 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.
- LLC: No salary required. All income is treated as pass-through entity income.
- S corp: Must pay W2 salary to working owners. Profits beyond salary are treated as distributions.
Owners of S corps—if they actively work for the company—must be compensated with a reasonable 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.
- LLC: Partnership tax, pass-through income tax, self-employment tax.
- S corp: Salary subject to payroll and income taxes. Distributions taxed as ordinary 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. The self-employment tax rate is 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.
- LLC: No limit on number of members, flexible ownership structure, no board of directors required.
- S corp: Maximum of 100 members, must have a board of directors.
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 of an LLC there are. 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.
- LLC: Simple set up, articles of organization, operating agreement.
- S corp: Complex set up, corporate bylaws, annual shareholder and board of directors meeting.
It’s simple to start an LLC; you need articles of organization and an operating agreement to file within the state law. 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.
LLC vs. S corp: Choosing the best option for you
Choosing between an S corp and an LLC depends on your specific business needs and goals. Consider the following factors when making your decision:
- Tax purposes and potential savings
- Ownership restrictions and preferences
- Management structure and flexibility
- Ease of formation and ongoing requirements
It’s advisable to consult with a business attorney or tax professional to discuss your unique situation and determine the best business structure for your needs.
An S corporation may be best for you if:
- You’ll benefit from pass-through taxation, avoiding double taxation
- You have 100 or fewer shareholders
- Your shareholders are US citizens, resident aliens, or certain trusts and estates
- You desire limited liability protection for shareholders
- You want flexibility in allocating personal income and losses
- You aim to save on self-employment taxes for shareholders
- You only need one class of stock
- You prefer a simpler corporate structure with fewer regulations
- You plan to distribute profits according to ownership shares
- You may want to easily convert to a C corp in the future
An LLC may be best for you if:
- You want to protect your personal assets from potential business debts or lawsuits
- You prefer the option to choose between being taxed as a sole proprietorship, partnership, or corporation, depending on your business needs
- You want a business structure with fewer formalities and paperwork compared to a corporation
- You prefer pass-through taxation, where business profits and losses are reported on your personal tax return
- You want the freedom to have any number of owners (members) in your business, including individuals, corporations, or other LLCs
- You seek flexibility in allocating profits and losses among members, rather than a fixed distribution based on ownership percentages
- You prefer the option to choose between member-managed or manager-managed structures
- You want to enhance your business’s credibility by having a formal business structure that shows potential clients, investors, and partners that you are serious about your venture
- You are comfortable with the regulations and requirements specific to the state where you plan to form the LLC, including fees, annual reports, and taxes
- You believe your business has the potential for growth, and an LLC structure can provide a solid foundation for scaling and potentially attracting investors
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 as an entrepreneur.