When opening up a new business or setting up an online store, you’re faced with the question of whether an LLC or S-corp is the right legal formation for you and your needs.
These two business models can make a significant difference in how you run your company from legal, tax purposes and management perspectives. Here’s what you need to know.
What is an LLC?
A limited liability company (LLC) is a legal entity formed at the state level. An LLC exists separately from its owners—known as members. However, members are not personally responsible for business debts and liabilities. Instead, the LLC is responsible.
The possibilities for how to structure an LLC are almost endless, which can be a blessing and a curse. This makes interfacing with an LLC challenging, because one has to examine the operating agreement (and potentially other contracts signed between the members) to get a handle on how the company is governed.
Corporations, by comparison, are more standardized: They share commonalities like stock to represent ownership, are governed by a board of directors, have day-to-day operations handled by officers.
What is an S-corp?
An S corporation is a regular corporation that has elected “S corporation” tax status. Forming an S corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or a partner in a partnership.
In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money they receive from the corporation as salary, bonuses, or dividends.
In an S corporation, all business profits “pass through” to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships, and LLCs).
The S corporation itself does not pay any income tax, although an S corporation with more than one owner must file an informational tax return, like a partnership or LLC, to report each shareholder’s portion of the corporate income.
LLC and S-Corp Comparison Chart
When starting a business, LLCs and S corporations are two terms that are often discussed side-by-side, they actually refer to different aspects of a business. An LLC is a type of business entity, while an S corporation is a tax classification.
An S corporation election lets the Internal Revenue Service (IRS) know that your business should be taxed as a partnership and to become an S corporation, your business first must register as a C corporation or an LLC and meet specific guidelines set by the Internal Revenue Service (IRS) in order to qualify.
|Qualifications||No restrictions when forming LLC||100 shareholders max|
|Can be owned by individuals, corps or foreigners||Owners must be US citizens/green card holders or have filed personal US tax returns for last 2 yr|
|No more than 25% passive income (income from rents/investments)|
|Only have 1 class of stock|
|Liability||Limited to amount invested||Limited to amount invested|
|Federal Tax Treatment||Pass through entity||Pass through entity.|
|Members pay taxes||Taxed once on shareholders|
|No LLC tax return||No corporate level taxation. Still file corp tax return|
|Self Employment Tax||Assessed on 100% of the profits if a single member LLC||Minimized by paying reasonable salary and taking dividends|
|Share of Profits & Losses||Share of profits/losses can be set by operating agreement & later by other agreement||Shareholders receive percentage of profits & losses based on percentage of shares owned|
|Record keeping||Board and shareholder annual minutes not required but recommended||Board annual minutes as well as shareholder annual minutes required|
|Annual report (fee typically $250)||Annual report (fee typically $100)|
|Recommended for||If holding real estate or long term investments||Best tax and liability protection|
|If varying income distributions from year to year||If you qualify then this is typically the best bet|
|Items needed or recommended||Indemnification Agreement||Indemnification Agreement|
|Operating Agreement||Shareholder Agreement|
|County Recording||Business Registration|
|Corporate Counsel||New Hire Reporting Forms|
Pros and Cons
Now that you know the differences between an LLC and an S-corporation, it’s time to see how those differences apply to your business and make a decision.
A business attorney or tax professional is the best-qualified person to go through your the benefits of an LLC as well as your books and financial statements and determine what’s in your business’s best interest.
That said, here are general things to keep in mind when choosing an LLC vs. S-corporation:
|LLC Advantages||S-corp Advantages|
|Flexibility to choose how you’re taxed (avoid double taxation)||Don’t pay federal taxes at the corp level|
|Pay lower annual fees||Can offer cash payments via dividends to incentivize employees and attract talent|
|Fewer governance requirements||Allow the owner to benefit from personal liability protection|
|LLC Disadvantages||S-corp Disadvantages|
|More difficult to raise money from investors||Some states don’t allow an S-corp to be taxed on the owner’s personal tax returns|
|S-corps can be slower to establish as a board of directors and corporate officers are required|
LLC vs S-corp taxation and liability protection
One of the main similarities between S corporations and LLCs is limited liability protection; both entities protect owners from the debts and liabilities of their businesses.
Both LLCs and S-corps are separate entities from their owners that are created by filing with the state. Both must file annual reports and pay fees for continued authorization to do business in their states.
However, while S corporations have to file business tax returns, LLCs do not need to file a tax return unless there is more than one owner.
C corporations are subject to double taxation because owners are taxed on their distributions or dividends, and the corporation is also taxed on its profits. S-corporations do not have this issue since all its income is passed directly to its owners.
Neither S corporations or LLCs pay income tax on their behalf because both have what is referred to as “pass-through taxation.” That means any profit or loss is passed through to the owners’ personal tax returns, and owners must pay tax on this income themselves.
Shareholders of an S corporation must use Form 1120S to report their salaries if they have any, and use Schedule K-1 to report the distribution of profits. LLC owners report their income distributions on their own personal 1040 form, Schedule C, or Form 1065 along with Schedule K-1.
If an LLC chooses to be taxed as an S corporation, owners follow S corporation tax reporting guidelines.
Which one should I choose?
Both LLCs and S Corporations will give you a certain amount of personal liability and overall legitimacy. If you are looking to upgrade from a sole proprietorship or partnership, either of these are good options.
For small business owners or sole proprietors, an LLC is often the easiest and most cost-effective way to incorporate.
A business owner who wants to have the maximum amount of personal asset protection plans on seeking substantial investment from outsiders or envisions eventually becoming a publicly-traded company and selling common stock will likely be best served by forming a C corporation and then making the S corporation tax election.
It is important to remember that the S corporation designation is merely a tax choice made to have your business taxed according to Subchapter S of Chapter 1 of the Internal Revenue Service Code.
Choosing the right business structure will therefore depend on the size and scope of the company, the number of employees, the level of involvement of the owner(s), and tax considerations.
Should I Make My LLC an S Corp?
If you’re a sole proprietor, it might be best to establish an LLC since your business assets are separated from your personal assets. You can always change the structure later or create a new company that’s an S corporation.
An S corporation would be better for more complex companies with many people involved since there needs to be a board of directors, a maximum of 100 shareholders, and more regulatory requirements.
Which is better, an S Corp or an LLC?
An LLC is often better for a single-owner and likely better for a partnership. An LLC is more appropriate for business owners whose primary concern is business management flexibility.
Do S corps pay quarterly taxes?
Yes, S corporations pay quarterly tax and need to file an IRS Form 941 to report the aggregate amount it withholds. The form is due four times a year, typically on January 31, April 30, July 31 and October 31.
Is it better to be a single member LLC or S Corp?
This depends on the business circumstances. The main difference is in a single-member LLC, only the business owner can report business profit/losses on their personal taxes, whereas in an S-Corp, all shareholders can.
Tom is the founder of Gottagrow.io. He reads the offers, deciphers the details including features, pricing, included services and more to find you the best products and services.