This article provides a comparison between Limited Liability Companies (LLCs) and Subchapter S corporations (S corps). It explains that LLCs offer flexibility, limited liability protection, and pass-through taxation, while S corps provide tax advantages, such as savings on self-employment taxes, and are suitable for businesses with investors or those seeking a comprehensive retirement plan.
Choosing the structure of your business is a decision that calls for considerable attention to your options and what they each offer. You have to understand your business's present and future needs for the best structure. Two popular options for any enterprise are a Limited Liability Company (LLC) or an S corp. Here is an LLC vs S corp breakdown of these two structures to help you guide in picking the one that is right for your business.
What is an LLC?
A Limited Liability Company is a legal business entity that combines the flexibility advantages of a partnership with the limited liability protection of a corporation. LLC owners are known as members; an LLC could be a single-member LLC or a multi-member LLC.
There are two main distinguishing factors of an LLC. First, LLC members are not personally liable for the debts or liabilities of the company, meaning that their assets are protected if the business runs into financial trouble. Secondly, by default, LLCs are taxed as pass-through entities; that means that the business’ profits and losses are passed through to the individual members, who report them on their tax returns.
An LLC is a preferred option for most small and medium enterprises for its liability protection while having fewer regulatory requirements than a corporation.
What is an S Corp?
A Subchapter S corporation (S corp) is not a business entity but a tax classification. It refers to a tax election in the Internal Revenue Code which informs the IRS to grant the business pass-through taxation benefits.
An S corp ensures the business’ profits are not doubly taxed, that is, under corporate and then under the owner. Business owners in an S corp are known as shareholders. As a business owner, you can be an employee, and the IRS requires you to pay yourself a reasonable salary. This salary is subject to federal and state income tax and other deductions. However, you also get another form of compensation through your share of company profits for the shareholders, known as distributions. These are not subject to self-employment taxes.
You will need to have an LLC or a C corporation to enjoy the S corp classification. On top of that, your business should meet several requirements, including;
- Meet the domestic status: The business must be incorporated in the United States and be a valid corporation under state law.
- A maximum number of shareholders: The S corporation can have no more than 100 shareholders, and they must be individuals, estates, and certain types of trusts, and they must be U.S. citizens or residents. Partnerships, corporations, and non-resident aliens cannot be shareholders in an S Corporation.
- Only one class of stock is allowed: The S corporation must have only one class, either common or preferred stock. This requirement means that all outstanding shares must have the same voting rights and the same rights to distributions and liquidation proceeds.
- Not be an ineligible corporation: Certain types of businesses, such as financial institutions, insurance companies, and domestic and international sales corporations (DISCs), are not eligible for S corporation status.
- File Form 2553: To elect S Corporation status, the business must file Form 2553, Election by a Small Business Corporation, with the IRS. The form must be filed no later than two months and 15 days after the beginning of the tax year in which the election is to take effect.
S corp vs LLC: What are their differences?
The main differences between an S corp and an LLC are over the following aspects;
- Ownership structure: S corporations are limited to 100 shareholders, all of whom must be U.S. citizens or residents. In contrast, LLCs can have unlimited members, and there are no restrictions on the types of entities or individuals that can be members.
- Management structure: S corporations must have a board of directors and officers responsible for managing the business. On the other hand, LLCs can be managed by the owners themselves or a designated manager.
- Owner employment: In an S corp, owners who work for the company must receive a reasonable salary and are subject to payroll taxes. In contrast, owners of an LLC can take profits without paying payroll taxes, although they are subject to self-employment taxes.
- Stock: S corporations issue stock to shareholders, representing ownership in the company. LLCs do not issue stock; membership interests represent ownership.
- Tax liability and reporting: S corporations are considered pass-through entities for tax purposes, which means that the profits and losses of the business pass through to the shareholders' tax returns. LLCs can also be taxed as pass-through entities, but they also have the option to be taxed as a C corporation or an S corporation.
- Allocation of profits and losses: In an S Corporation, profits and losses are allocated based on each shareholder’s stock percentage. In an LLC, profits and losses are allocated according to the operating agreement, which can be based on ownership percentage or other criteria.
- Transferability of ownership: Shares of an S Corporation can be bought and sold, but there are restrictions on who can own stock. In an LLC, ownership interests can be bought and sold more easily, although transfer restrictions can be included in the operating agreement.
S corp vs LLC: Are there any similarities?
There are a few similarities between these two structures, with the main ones being;
- Limited liability protection: Both LLCs and S corporations offer limited liability protection to their owners. This provides protection over the owner’s personal assets from the business's debts and liabilities.
- Pass-through taxation: LLCs and S corporations are considered pass-through entities for tax purposes. This means that the business itself does not pay taxes on its profits; instead, the profits and losses are passed through to the owners' personal tax returns, and they pay taxes on their share of the profits.
- Business legitimacy: Both LLCs and S corporations offer a level of legitimacy to a business. By registering as an LLC or S corporation, a business is recognized as a separate legal entity, which can help to establish credibility with customers, suppliers, and investors.
When is an S Corp the better choice for me?
Depending on the position of your business and future plans, it may make more sense organization-wise and financially to choose an S corp classification. Primarily, it is a structure to choose when you are scaling up the business or have reached consistent growth levels, which allows you to enjoy the following advantages of an S corp;
1. Tax savings in self-employment taxes
With higher profits, the self-employment tax becomes considerable. The 15.3% self-employment tax is steep if you are earning more. With an S corp classification, owners can receive a reasonable salary and take the rest of their income as distributions, which are not subject to self-employment taxes. You can make further tax savings with an S corp by;
- Using the S corp to pay health insurance premiums which you then use to get tax breaks
- Write off the company’s payroll, including your salary
- Delay tax payments on retirement income until the time for withdrawal
- Write off reimbursed employee expenses.
2. You need investors
If you seek investors or commercial lenders, an S corp classification will be the right fit. Investors have more trust in corporations, and most VCs restrict their investments to S corps. Even commercial lenders are more familiar with a corporate structure which an S corp structure offers. Thus, if you plan to seek funding, an S corp makes your business more attractive.
3. You want a comprehensive retirement plan
An S corp has a better built-in retirement plan offering options that an LLC could not. S corporations can offer employees built-in retirement plans, such as a 401(k) plan, which may be more difficult and expensive to set up in an LLC.
4. You want to take an active role in managing your business
If you want to provide services to your organization in any role, an S corp provides a more cost-effective way to achieve this. You get a considerable salary and enjoy pass-through taxation benefits on your second compensation as distributions.
When is an LLC the better option for me?
The LLC is a better option if you are starting or are looking for a structure that’s easier to manage, especially when transitioning from a sole proprietorship or partnership and you want limited liability protection. Here are some LLC vs S corp scenarios where choosing an LLC structure may be advantageous over an S corporation:
- Simplicity: LLCs are generally less complicated and expensive to set up and maintain than S corporations. There are fewer formalities required to operate an LLC, and there are no restrictions on ownership, allowing for greater flexibility.
- Management flexibility: LLCs offer more flexibility in management structures. Members can manage the LLC or hire a manager to handle the day-to-day operations.
- No limits on ownership: LLCs can have unlimited members, and there are no restrictions on the types of entities or individuals that can be members. On the other hand, S corp is limited to 100 shareholders, and all shareholders must be US citizens or residents.
- Tax benefits for certain businesses: LLCs can be advantageous for certain types of businesses with significant deductions, as the losses can be passed through to the owners and offset other sources of income. In contrast, S corps are subject to restrictions on losses and deductions.
- Passive ownership: LLCs may be a better choice for businesses with passive ownership or investment structures, as the structure allows for greater flexibility in the distribution of profits and losses.
Getting started on corporation formation
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FAQs on LLCs vs S Corp
Which structure is better for taxes, LLC or an S corp? ✕
Generally, an S corp structure offers more tax advantages than an LLC. While both structures enjoy pass-through taxation, an S corp has the advantage of being able to save on self-employment taxes. S Corporation owners who work for the business can receive a reasonable salary and take the rest of their income as distributions, not subject to self-employment tax.
Can you change from LLC to S corp? ✕
Yes, you can change an LLC to an S corp by making an election with the Internal Revenue Service (IRS) by filing Form 2553, the Election by a Small Business Corporation form. The LLC should also meet the requirements of an S corp for a successful filing, as not every LLC can be an S corp.
Can an LLC own an S corp? ✕
Yes, but only if the LLC is a single-member LLC that is treated as a disregarded entity for federal tax purposes and it meets the eligibility requirements to be an S corporation shareholder.
An S Corp can own an LLC, and this ownership structure provides certain benefits for the S Corp, such as additional liability protection and greater flexibility in structuring the ownership and management of the LLC.
Which is the better option LLC or an S corp? ✕
There is no blanket right answer, as the decision between an LLC and an S Corp should be based on factors such as the size of the business, the number of owners, the desired management structure, and the tax implications of each entity type, among other things. While both entities offer liability protection, LLCs have fewer formalities, such as fewer reporting requirements and no annual meetings, and offer greater flexibility in management structure and profit-sharing arrangements. On the other hand, S Corps can provide tax benefits, such as avoiding self-employment taxes on a portion of the business income.
Which is the cheaper structure LLC or S corp? ✕
Generally, forming an LLC is less expensive and more straightforward than forming an S Corp, as LLCs have fewer formal requirements and fewer ongoing compliance obligations. However, at other times tax implications may vary depending on the individual business, and an S corp could be cheaper in some cases.