Limited liability companies (LLCs) and Subchapter S corporations (S corp) are often discussed together, but this is misleading. The difference between an LLC and an S corp is that an LLC is a business entity while an S corp is a tax classification.
Whether you're curious about establishing an LLC or launching an S corporation, starting a business is an exciting undertaking full of learning experiences. You can use this guide to sort out the differences between LLC vs. S corp to make the best decision for your business.
Key takeaways
- LLCs and S corporations offer different levels of liability protection, taxation benefits, and management structures.
- Consider risk level, asset protection, and the number of owners/employees when deciding which entity best suits a business's needs.
What is an LLC?
A limited liability company is a legal designation that can protect small-business owners from personal liability in business obligations. Owners of LLCs are known as members. Limited liability companies can have one owner (single-member LLC) or more than one owner (multi-member LLC). Owner-employees of LLCs are self-employed.
LLCs offer a formal business structure and can be taxed similarly to sole proprietorships or partnerships. An LLC is more flexible than a corporation in organization and profit distribution. A limited liability company can also choose taxation as a corporation, and owners can save money by electing S corp tax status.
There are several benefits to owning an LLC or limited liability company. A main benefit is limited personal liability in that if the business owes money to a creditor, the owner's personal assets will not be used to pay off that debt. There also tends to be less paperwork involved in the development of an LLC. Additionally, the owner of an LLC has the advantage of taking on the tax status of a sole proprietor.
What is an S corp?
An S corporation is a tax classification that can protect small-business owners' assets from double taxation. An S corp utilizes pass-through taxation, meaning an owner claims a share of company profits on their tax return. This ensures that C corporation (aka C corp) profits aren't double-taxed (once under the corporation and again under the owner).
The “S" in S corp stands for “subchapter" because an S corp is a subchapter corporation. When incorporating a business, you'll first form a C corp that must meet S corp requirements to be so classified. The requirements include electing S corp status two months and 15 days after officially organizing your business (for the status to affect the current tax year), capping ownership at 100 individuals (not entities or partnerships), and limiting those owner shares to U.S. citizens only.
S corp owners can be company employees. Owner-employees must pay themselves a reasonable salary for their work. They'll pay federal taxes and state income taxes, Medicare, and Social Security tax on that salary. Owners receive additional profits as distributions, which aren't subject to Medicare and personal income tax or Social Security taxes.
There are several advantages of choosing an S corp structure over other structures. When choosing the S corp structure, the owner's personal assets, such as their personal bank accounts or their home, cannot be taken in the case of litigation. There are also savings on health insurance and employee expense reimbursements. S corps can also use a cash-basis method of accounting. This is where revenue and expenses are recorded at the moment cash is received or spent.
Liability protection in LLCs and S corporations
Liability protection is a crucial consideration for business owners, as it safeguards their personal assets from the company's financial obligations. Both limited liability companies and S corporations offer limited liability protection, ensuring owners are not personally responsible for the business's debts and liabilities. However, there are some distinctions between the two regarding liability protection.
For instance, an S corporation's existence is generally perpetual, which is not typically true with an LLC. Additionally, an LLC with more than one member cannot purchase or own S corp stock, and an LLC cannot purchase a membership interest in an S corp. A single-member LLC can be taxed as a disregarded entity. This type of LLC may potentially own S corp stock.
Ultimately, both structures provide substantial liability protection, but the specific differences may influence your decision based on your business's unique needs.
Taxation differences between LLCs and S corporations
Taxation is a key area where LLCs and S corporations differ significantly. By default, LLCs can be taxed as sole proprietorships or partnerships, depending on the number of members. This means that the LLC's income is passed through to the owner's tax return, and the owner is responsible for paying taxes on the profits at their tax rate. On the other hand, S corporations offer pass-through taxation, which allows corporate taxes or income, losses, deductions, and credits to flow through to the shareholder's tax returns.
One potential advantage of an S corp is avoiding self-employment tax on a portion of the owner's income. In an S corp, only owner-employee salaries are subject to FICA taxes for Social Security and Medicare. Any additional profits distributed to shareholders are not subject to these taxes, which can result in significant tax savings. This contrasts with an LLC, where owners may be subject to self-employment tax on all net earnings from the business.
However, remember that not all businesses qualify for taxation as S corporations. To elect S corp status, a business must meet specific requirements, such as having no more than 100 shareholders, being in the U.S., and filing as an American corporation with the Internal Revenue Service. Depending on your business' specific circumstances, the potential tax advantages and savings of an S corp may outweigh the simplicity of an LLC's pass-through taxation.
What's the difference between an S corp and an LLC?
As we explained above, an S corp is a tax classification, while an LLC is a business entity. This means an LLC can attain S corporation status if it meets certain criteria. However, LLCs and S corporations require different management and shareholder structures and have unique reporting requirements. We'll dig into these differences below.
Owner employment
S corporation can employ their owners and pay them a salary. An LLC treated as a corporation can also pay owners a salary. If your LLC makes a profit after paying owners a reasonable salary, you might save money on taxes by electing S corporation taxation.
Key takeaways:
- S corp: Owner can be hands-off or take a salary as a company employee
- LLC: Owner can be hands-off or participate in organization management
Ownership structure
By default, an LLC operates like a sole proprietorship or partnership. That being said, most LLCs are run by the terms of their operating agreement. An operating agreement is a document filed with the Secretary of State to give them the basic facts about your business; it is also a place for you to lay out the rules for how your company will be run. You can create one by utilizing an operating agreement template. However, it would be best to consult an attorney to ensure clarity on ownership distribution, decision-making authority, management responsibilities, and state-specific laws. An LLC can have unlimited owners (members) worldwide, and these owners can also be another corporate entity.
An S corp must be a U.S. business owned by U.S. citizens and cannot have more than 100 owners. Beyond individuals, S corporations limit ownership to trusts and estates.
Key takeaways:
- S corp: 100 or fewer owners; must be U.S. citizens or U.S.-based trusts
- LLC: Unlimited owners with no restrictions on classification or nationality
What is a limited liability partnership?
A limited liability partnership (LLP) is a business entity with a flexible legal and taxation structure that allows each member to have limited personal liability for the partnership's obligations or claims. Each partner is responsible for what they invested in the business and shares tax consequences.
The benefit of having partners over a sole proprietorship is the ability to spread risk, take advantage of individual expertise, and divide labor in a way that leverages the skills of each partner. Similar to an LLC, if the partnership fails in any way, then each partner's personal assets and income are considered safe from creditors. Businesses like law firms, accounting firms, wealth management firms, and medical offices tend to enjoy the benefits of the LLP business structure.
LLPs are also not obligated to take on the structure of a corporation that involves the addition of shareholders, annual meetings, the election of directors, or other such activities.
Management structure of LLCs vs. S corporations
Regarding management structure, LLCs and S corporations differ in several ways. LLCs offer more flexibility in management and profit allocation, allowing owners to manage the business as they see fit. This can be especially advantageous for small businesses and sole proprietorships that require a more adaptable management structure.
In contrast, an S corp has a more rigid structure, requiring a board of directors and corporate officers to manage the company. The more formalized management structure of an S corp may be suitable for larger, more complex companies that require a more organized and hierarchical approach. Additionally, S corporations have the following limitations:
- They are limited to one class of stock, which can affect the company's ability to raise capital and attract investors.
- They have restrictions on the number and type of shareholders they can have.
- They have limitations on the types of businesses that can qualify for S corp status.
- While both structures have their merits, the decision between an LLC and an S corp will depend on the specific needs and preferences of your business.
Key takeaways:
- S corp: Shareholders choose a board of directors; officers run daily operations
- LLC: Managers run daily operations and can appoint officers if desired
One class of stock
An S corp can only issue common stock, which gives voting rights to shareholders. An LLC cannot issue stock and does not have shareholders but must pay members according to the LLC's articles of organization. If you decide to incorporate your LLC with S corp classification, you can't issue stock.
Key takeaways:
- S corp: Common stock with shareholder voting rights
- LLC: No stock or shareholders at all
Tax liability and reporting requirements
Taxes play a significant role in deciding between an S corp and an LLC. Both structures offer pass-through taxation, which prevents double taxation faced by a C corp. However, S corp can provide a tax benefit by allowing owners to pay themselves a salary, while LLC owners are subject to self-employment taxes on their entire income.
Standard taxation for LLCs mirrors sole proprietorships (for single-member LLCs) and partnerships (for multi-member LLCs). Single- and multi-member LLCs can also elect to be taxed as C corporations or S corporations if they meet eligibility requirements. Non-S corp LLC owners must pay a 15.3% self-employment tax on all net profits.
S corporations have looser tax and filing requirements than C corporations. An S corp is not subject to corporate income tax, and all profits pass through the company. A C corp must pay taxes quarterly in addition to owners paying annual income tax on their share of the profits.
Taxable income
According to U.S. tax law, there are several categories of taxable income for LLCs and S corps. In general terms, any amount that is included in your income is considered taxable income unless exempted by law. Under the Internal Revenue Code, all taxable income is required to be reported on your yearly returns and is subject to tax. It is possible that some nontaxable income will still have to be reported as income but will be categorized as nontaxable when filing annual reports.
Self-employment taxes
One of the main differences between an S corp and a limited liability company is the treatment of self-employment taxes. With an S corp, owners can pay themselves a salary subject to payroll taxes, while the remaining profits are distributed as dividends and not subject to self-employment taxes. This can result in significant tax savings, especially for businesses with substantial profits.
On the other hand, limited liability company owners are subject to self-employment taxes on all net earnings from the business, which currently stands at 15.3%. This and other business expenses can be a considerable cost for LLC owners, especially those with high incomes derived from their business income because they need to pay self-employment tax.
Pass-through taxation
Pass-through taxation is a common feature of both S corporations and LLCs, allowing the profits and losses of the business to be reported on the owners' personal tax returns, thereby avoiding double taxation. This can be a significant advantage for small businesses, as it simplifies tax reporting and can result in tax benefits and lower overall tax liabilities.
Despite both S corp and LLC benefitting from pass-through taxation, we should note that S corp faces stricter ownership and management structure regulations than LLC. Therefore, business owners who value flexibility and simplicity may find LLC a more suitable option.
Key takeaways
- S corp: Owners can take a salary and avoid self-employment taxes on the rest of the profits
- LLC: Owner must pay self-employment tax on all net profits if taxed as a sole proprietorship or partnership
Cost to establish
The cost of establishing an LLC and electing S corp status can vary depending on factors like your state and whether you conduct business across state lines. Legal help will cost extra but will likely save you money and time while helping you avoid common mistakes.
The average cost of filing articles of incorporation, not including lawyer or accounting fees, or other annual fees, ranges from $100 to $250, depending on the particular state you file in. Forming an LLC costs between $0 and $500, depending on the state. If you do business in other states as an LLC, you'll need to register to conduct business in each state, which will cost an additional foreign business registration fee.
Key takeaways
- S corp: incorporation fees range from $100 to $250
- LLC: formation fees vary from state to state, ranging from free to $500
Ideal business sizes for LLCs and S corporations
When comparing LLCs vs. other business structures, limited liability companies are often more appropriate for small businesses and sole proprietorships due to their flexibility in management structure and pass-through taxation. This allows small business owners to easily manage their business entity while also receiving the benefits of liability protection. Furthermore, the simplicity of establishing and maintaining an LLC can be an advantage for business owners who prefer a more streamlined approach to their company's structure.
On the other hand, S corporations are more suitable for larger, more complex companies that require a more structured and hierarchical management approach. Additionally, S corporations can:
- Issue stock, which may be attractive to investors and can facilitate growth opportunities
- Have a maximum of 100 corporation shareholders
- Have restrictions on the types of shareholders allowed
However, it's important to remember that not all companies are eligible to be S corporations, and certain shareholder limitations need to be considered.
Income threshold for S corp consideration
Companies with an annual profit of $80,000 or greater may find that electing S corp status can result in tax savings. By converting to an S corp, owners can potentially reduce the business income subject to self-employment tax, thereby decreasing their total tax payments. This could greatly benefit businesses generating substantial profits, as tax savings can be reinvested or distributed to shareholders. Nonetheless, it's crucial to balance these potential tax savings against the added complexity and compliance requirements to take advantage of S corp status before deciding.
Growth potential and investor attraction
The growth potential of your business operations can influence your decision between forming an LLC or an S corp. While LLCs provide a flexible management structure and pass-through taxation, they may face limitations in raising capital due to their inability to issue stock. This can make it more challenging for LLCs to attract investors and secure funding for expansion.
In contrast, S corporations can:
- Issue stock
- Be more appealing to investors looking for equity in a company
- Facilitate growth opportunities by providing access to capital that can be used for business operations expansion, hiring employees, or investing in new technologies
However, remember that S corporations are restricted to 100 shareholders, which can limit their growth potential compared to C corporations, which have no shareholder limit.
Is it better to have an S corporation or an LLC?
While every business owner should decide which business structure is right for them based on their business needs and business plan, for most small businesses just starting, it is better to choose an LLC instead of an S corporation.
With the cost to start an LLC ranging from free to $150, starting an LLC is more affordable than starting an S corp, which can range from $100-$250. Forming an LLC also gives business owners flexibility in running the business. One person can own your new LLC as a single-member LLC, or you can bring in multiple owners as a multi-member LLC. Forming an LLC also has fewer formalities and reporting requirements. An LLC is governed by your operating agreement, which lays out how you want your new business to function. It also makes your LLC less expensive to manage.
Key takeaways
- LLCs are easier and less expensive to form
- LLCs require less reporting and can be easier to manage
- S corp formation fees can be more expensive
- S corporations have a limited number of owners/shareholders
- S corporations have more complicated reporting and record-keeping
Why would someone choose an S corp over an LLC?
For businesses that want to focus on growth and scalability, it may be better for you to form an S corp instead of starting an LLC. Here are some pros and cons of starting an S corp.
S corp pros
- Being taxed as a pass-through entity can result in lower taxes
- Allows owners to avoid self-employment taxes by paying themselves a salary
- Able to access additional profits and distribution that are not subject to self-employment taxes
- Good for companies with an eye toward growth
S corp cons
- More formalities in the form of shareholder meetings and maintaining a board of directors
- An S corp can not have more than 100 shareholders
- All shareholders must be U.S.-based
- Stricter eligibility requirements
- Tax qualifications need to be met to keep S corp status
- S corporations have to adopt a calendar year unless they can show a business purpose for having a fiscal year
- Closer IRS scrutiny
- Less flexibility for allocating income and loss
LLC vs. S corp: Which option is best for you?
LLCs and S corporations are different aspects of business structure. Pursuing one, both, or neither classification could benefit your business differently. Consider your needs when running a business, and ask yourself the following questions to understand better which designation is right for you.
- How many owners have a stake in your business?
- Are all of your business partners U.S. citizens?
- Does a partnership or corporation have a stake in your business?
- How would a self-employment tax affect your net profit?
The answers to these questions can help you determine the fit of an LLC designation or S corp—classification for your business.
An S corp may be best for you if:
S corp tax classification might be best for your business if you have plans to scale. S corporations require additional tax forms and payroll systems, which might not be worth the hassle if your business breaks even or makes a small profit. With an S corporation, you can contribute more money to retirement plans and position your business for growth.
Separately, an S corporation might be right for you if your company reaches a consistent level of growth. A 15.3% self-employment tax levied on an LLC's profits is a steep tax liability to pay when revenues begin to tick upward.
An LLC may be best for you if:
You may want to establish an LLC if you're concerned about personal liability but want minimal business upkeep. Legal requirements dictating the structure of an LLC are more lax than upkeep requirements for S corporations.
Reporting requirements are generally simpler for an LLC than for an S corp. An LLC can have an unlimited number of owners. Partnerships, corporations, or noncitizens can own or partially own LLCs. The LLC should file annual reports or biennial reports that give updates on current members, business locations, and other changes.
Converting from an LLC to an S corp
If you decide that an S corp structure would be more advantageous for your business, it is possible to convert an existing LLC to an S corp. This process involves filing Form 2553 with the Internal Revenue Service and meeting specific requirements to elect S corp status. The forthcoming sections will detail the steps for converting an LLC to an S corp and discuss the potential merits of such a transition.
Before proceeding with the conversion, it's essential to consult with a corporate lawyer or accountant to ensure that your business meets the necessary requirements and that the potential benefits of S corp status outweigh the costs and complexities associated with the change.
Steps to convert an LLC to an S corp
To convert an LLC to an S corp, you'll need to file Form 2553 with the IRS. This form, also known as the “Election by a Small Business Corporation," allows your LLC to elect S corp status for tax purposes. You can find the instructions for completing Form 2553 directly on the form itself.
In addition to filing Form 2553, you'll need to ensure that your LLC meets specific requirements to qualify for S corp status. This includes having fewer than 100 shareholders, obtaining shareholder consent for the S corp election, and adhering to any other requirements set forth by the IRS. By following these steps, your LLC can successfully convert to an S corp and potentially reap the benefits associated with this business structure.
Benefits of converting to an S corp
There are several potential benefits to converting your LLC to an S corp. One of the most significant advantages is the potential tax savings, particularly in terms of self-employment tax. By electing S corp status, only the wages paid to owner-employees are subject to FICA taxes for Social Security and Medicare, which can result in considerable tax savings. Furthermore, the remaining earnings after the profit distribution are not subject to self-employment tax, allowing you to retain more of your business's profits.
In addition to tax savings, converting to an S corp can also provide employment tax benefits and open up growth opportunities for the business. For example, an S corp can issue stock, which may be attractive to investors and can be used to raise capital for business expansion. However, it's important to carefully weigh the potential benefits against the increased complexity and compliance requirements associated with S corp status before deciding.
Make an informed decision
In conclusion, choosing the right business structure for your company is a critical decision that can significantly impact your business's success. LLCs and S corporations offer unique tax advantages and potential drawbacks, depending on your business needs and objectives. By understanding the key characteristics of each structure and the factors to consider when deciding between them, you can make a more informed decision that will set your business up for success.
As you embark on your entrepreneurial journey, remember that choosing between an LLC and an S corp is not set in stone. You can always reassess your business's needs and growth potential as it evolves and change your structure accordingly. By staying informed and adaptable, you can ensure your business thrives under the most suitable structure for its unique needs and goals.
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