Deciding on the right entity type is imperative to the success of your business. Each business structure comes with its own set of advantages and disadvantages. Therefore, the type of structure you choose will all depend on your company’s goals, size, and the benefits you would like to enjoy. For example, limited liability companies and S corporations are quite popular entity types since each offers liability protection and tax advantages. The following guide will outline the differences between an LLC vs. an S corporation and ultimately help you make an informed decision.
What is an LLC?
A limited liability company is a legal business entity formed under state laws. LLCs require formal registration, and when one member is involved, it’s known as a single-member LLC. However, when more than one member is involved, it’s called a multi-member LLC. In a multi-member LLC, the option to have the company managed by members or an outside manager is available. Ultimately, an LLC is a separate legal entity from its members and, by default, enjoys the same tax-paying status.
- Protection of personal assets: Entrepreneurs and small business owners find the LLC business structure appealing because it offers protection of personal assets, also known as personal liability protection.
- Credibility: Since LLCs are seen as more formal business structures, they have more credibility with financial institutions, clients, and suppliers.
- Flexibility of ownership: LLCs can be owned by individuals, partnerships, corporations, trusts, and foreign entities. Additionally, an LLC can have any number of members.
- Ongoing compliance: When compared to corporations, LLCs have much more leniency regarding ongoing compliance requirements.
- Pass-through taxation: LLCs are taxed at the individual level, and the members of the LLC will submit personal income tax returns as opposed to the company submitting corporate taxes.
- Management structure: LLCs may be managed by the owners or members; alternatively, they may need to hire an individual not a part of the LLC to maintain day-to-day operations.
- LLC costs: When compared to forming a sole proprietorship or partnership, it costs far more to form an LLC. Additionally, there are ongoing annual fees and filing fees associated with LLCs.
- Transfer of ownership: While it’s possible to have new members brought into the company continuously, the consent of existing members must be given. The only way to avoid this is to have an operating agreement that states that new members can be brought on without prior consent from existing members.
Read more about LLC types.
What is an S corporation?
An S Corporation is a tax classification rather than a business entity type. Both corporations and LLCs may be taxed as S corporations. One of the major differences between S corporations and normal corporations or LLCs is that S corps do not pay corporate income tax as traditional C corporations do. Instead, business profits are passed through to the owner’s personal tax returns.
To experience the tax benefits or tax savings afforded by an S corporation, you must meet certain criteria, such as:
- You can only have one class of stock.
- Shareholders are not allowed to be non-resident aliens, partnerships, or corporations.
- Shareholders may be individuals and certain estates and trusts.
- There cannot be more than 100 shareholders or small business owners.
- You must be a U.S. business.
Both corporations and LLC entity types can enjoy the benefits of S corporate taxation. Therefore, if you’ve formed a corporation, you can elect S Corp status, allowing you to avoid company profits taxed at both the corporate and shareholder level. Additionally, if you’ve formed an LLC, you can still elect the S Corp tax status allowing you to be considered a company employee and potentially saving you money on taxes.
S corporation benefits
- Ease of conversion: For S corporations to be taxed as C corporations, they need to elect the C corp status with the IRS.
- Salary and dividend payments: S corporations are entitled to receive both the dividend and salary payments from the corporation, resulting in lower tax bills overall.
- Flow-through taxation: One of the major benefits of electing S corporation status is the flow-through taxation benefits. It entitles you to have tax deductions, losses, credits, and so on pass-through to the owners rather than the corporation being taxed at the business level. Therefore S corporations help you to avoid double taxation.
- Asset protection: Limited liability protection is one of the main advantages of S corporations, irrespective of tax status. So the owners’ personal assets are shielded from any claims, debts, and obligations brought against the company.
S corporation drawbacks
- S corp status requirements: There are strict requirements for electing the S Corp status. If these requirements are not met, you won’t be approved to operate as an S Corp.
- Corporate formalities: The default structure of an S Corporation is a C corporation. Therefore, they must go through all the formal requirements for creating and maintaining a corporation. When compared to an LLC, corporations have far more statutory formalities.
- Profit and loss allocation: How profits and losses are allocated is far more strict when compared to the way an LLC can allocate profits and losses. With S corporations, the losses and profits must be distributed amongst the shareholders and depend on the ownership percentage.
- Membership limitations: S corporations cannot have more than 100 shareholders.
At a glance: How is an LLC different from an S corp?
- When compared to a partnership or sole proprietorship, an LLC is a more formal business structure.
- Most people use the terms LLC and S corporation interchangeably; however, they refer to two different aspects of the business. While an LLC is a legal business entity or legal entity, an S corporation is more of a tax classification.
- When a business decides to elect S corporation status, it lets the Internal Revenue Service (IRS) know that the company must be taxed as a partnership.
- To elect S corporation status, your company must register as a C Corporation first or an LLC and meet certain criteria set out by the Internal Revenue Service to qualify for this tax classification.
Should I start an LLC or S corporation?
A limited liability company, also called an LLC, is a type of legal entity used when creating a business. When compared to a partnership or sole proprietorship, an LLC is a more formal business structure.
Most people use the terms LLC and S corp interchangeably; however, they refer to two different aspects of the business. While an LLC is a legal business entity or legal entity, an S corporation is more of a tax classification.
When a business decides to elect S corporation status, it lets the Internal Revenue Service (IRS) know that the company must be taxed as a partnership.
To elect S corporation status, your company must register as a C Corporation first or an LLC and meet certain criteria set out by the Internal Revenue Service.
LLC vs. S corporation taxes
It is possible to form and operate your company as an LLC but still be taxed as an S corp. Ultimately, there are several differences when you’re considering forming an LLC as an S Corp. Let’s take a look at the differences between how an LLC and an S Corp pay taxes.
- The income and losses of an LLC pass through the business and are instead reported on the owner’s personal tax return. This is called pass-through taxation, so an LLC is a pass-through entity.
- Therefore, the profits or income is taxed at the owner’s personal tax rate and not at the corporate level.
- If only one member runs the LLC, it’s referred to as a single-member LLC, and the structure is taxed as a sole proprietorship. Therefore, all deductions, losses, and profits reduce the taxable income reported on the owner’s personal income tax return.
- If the LLC has more than one owner, it’s referred to as a multi-member LLC, and each member reports losses and profits on their personal tax return.
- LLCs also avoid the double taxation that C corporations are subjected to since they pass all profits or company income through to the personal income tax returns of the individual members.
- LLCs are liable for self-employment taxes.
S corp taxes
- Once you elect S corporation status, you can pass corporate income, deductions, losses, and credits to the corporation’s shareholders for federal tax purposes.
- The shareholders report business income and losses on their personal tax returns. This is how S corporations avoid double taxation.
- Double taxation is when the company’s income is taxed at the corporate level (called a corporate tax), and the shareholders are also taxed on their personal tax returns for their dividend income.
- To file taxes, S corporations must use Form 1120S. This tax form reports S corporation shareholders’ losses, income, and dividends.
LLC vs. S corp: Formal requirements
LLCs and S corporations have formal requirements; however, they are different. Let’s have a look at them below:
Formal requirements for LLCs
- Compared to other business entities or corporate structures, the business requirements are much simpler for LLCs.
- LLCs are encouraged to follow the S corporation guidelines; however, they are not legally obligated to do so.
- Some requirements or suggested requirements include conducting annual shareholder meetings and adopting bylaws. However, instead of the detailed requirements for corporations to create corporate bylaws, LLCs may simply adopt an LLC operating agreement.
- The operating agreement contains terms and conditions and the roles and responsibilities of all members. The operating agreement is drawn up to accommodate the new business and accommodate future growth.
- Unlike corporations, LLCs do not need to maintain records of company meetings.
Formal requirements for S corps
- S corporations must file the Articles of Incorporation with the Secretary of State.
- S corporations also need a separate bank account for the business and a registered agent, and a tax identification number.
- An S corporation must also obtain the relevant licenses and permits to provide services in its selected industry.
LLCs are responsible for paying the necessary annual filing fees, submitting the necessary reports, and renewing licenses and permits. On the other hand, S corporations are subject to more stringent ongoing requirements like keeping the bylaws up-to-date, recording minutes of meetings, holding annual shareholder meetings, paying state and federal taxes, and obtaining licenses and permits to remain in good standing.
LLC vs. S corp: Management structure
There are quite a few similarities and differences between the management structures for LLCs and S corps. So let’s take a look at that below:
LLC management structure
- LLCs may choose to have the business managed by the members, or they may choose to hire an individual outside the company to run day-to-day operations.
- LLCs need to nominate a registered agent responsible for accepting legal documentation and service of process on the company’s behalf.
S corp management structure
- S corporations need to elect a Board of Directors who will be in charge of overseeing the operations of the corporation.
- Aside from electing a Board of Directors, an S corporation will need officers and a registered agent to accept the service of process and legal documentation on the corporation’s behalf.
LLC vs. S corp: Owner structure
The ownership structure between LLCs and S corporations is significantly different. So let’s take a look at those key differences below:
- LLCs can have an unlimited number of members or owners. The owners of an LLC are also allowed to be non-US residents, non-US citizens, and U.S. citizens.
- Any other type of corporation or entity type may own an LLC, and overall, LLCs face much less regulation in terms of how they are formed and ongoing maintenance.
S corporation ownership
- The Internal Revenue Service restricts ownership of S corporations or who can be S corp owners. Therefore, S corporations cannot have more than 100 owners or shareholders.
- They cannot be owned by any person who is not a U.S. citizen or permanent resident of the U.S.
- Other types of corporate entities are not allowed to own S corporations. These restrictions include ownership by C corporations, other S corporations, business partnerships, LLCs, and sole proprietorships.
When deciding whether to form an LLC or S Corp, you need to consider all the factors mentioned above. The type of industry you’re in, the size of your company, and your business goals will also play an important role in your decision. An LLC could be a good choice if you’re planning on going with a single-owner structure with business management flexibility. In other words, an LLC structure is suitable if you want to have a simpler, smaller, and more personally managed company. However, an S corporation structure would be appropriate if your business is more complex.
Whether or not you decide to incorporate as an LLC or S corporation will depend on several factors. However, one of the main differences between single-member LLCs and S corps is that with a single-member LLC, the company’s owner reports profits and losses on their personal taxes. However, with S corporations, all the shareholders can report profits and losses on their personal taxes.
While both business structures have advantages over each other, in terms of taxation, S corporations avoid double taxation. However, if you form an LLC and elect the S Corp. status, you can save money on taxes by allowing yourself to be taxed as a company employee.
One of the main disadvantages of forming an LLC is the high costs involved. Forming a partnership or sole proprietorship is significantly cheaper than forming a limited liability company. Initial formation fees, ongoing fees, franchise taxes, and annual report fees apply to LLCs.
Self-employed individuals are liable for self-employment taxes. Small business owners who don’t pay withholding taxes are also subject to self-employment tax. Self-employment taxes include Medicare and Social Security taxes that are reported to the IRS using Form 1040 Schedule S.E.
Yes, LLCs must nominate a registered agent, also known as a statutory or resident agent. This individual is responsible for accepting legal and official documentation from the state on your company’s behalf.