LLC vs. S-Corp: Which One is Right for You?
Looking to start your own company but are confused about the best options?
You have probably heard of an LLC and an S-Corp before. They are two of the most common types of business structures that small business owners choose when registering their company.
But which one is right for you?
Making the right decision will set you up for long-term success and could give you some excellent tax advantages.
In this article, we reveal the advantages and disadvantages of creating an LLC versus an S-Corp so that you can make the best possible decision for your small business.
Let’s start with some basic definitions of LLC and S-Corp.
What is an LLC?
LLC stands for limited liability company. It is a legal entity that combines the pass-through taxation of a general partnership with the liability protection of a corporation.
In 1977, Wyoming was the first state to approve the LLC. However, it is thanks to Delaware’s later efforts to streamline and promote this legal entity that almost two-thirds of all new businesses are LLCs.
Some features of the LLC are as follows:
- Its owners are called “members.”
- The members file “articles of organization” with the secretary of state’s office in order to register their company.
- An LLC protects its members’ personal property in the event that the business faces damages as the result of a lawsuit. This protection is called “limited liability” because there are times when personal property is fair game. One such instance is when a member uses their personal property to fund the business.
- LLCs must operate in the United States, even though the members don’t have to be U.S. citizens.
- Members can register an LLC in one state but operate it in another state or states, thus allowing members to choose the state with the most advantageous guidelines. When that happens, the LLC is called a “foreign entity.”
What is an S-Corp?
An S Subchapter corporation, or S-Corp, gets its name from the specific part of the IRS code that governs its rules.
Unlike an LLC, an S-Corp is not a legal entity. Rather, it is a tax status. The prospective business owner, or member, forms either a traditional C corporation or an LLC with the state and later files Form 2553 to elect S-Corp treatment.
According to the IRS, S-Corps are corporations that “elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S-Corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S-Corporations to avoid double taxation on the corporate income.”
Thus, S-Corps behave like corporations in some ways – you can sell stock to raise revenue, and the shareholders own the company – but like LLCs in other ways in its pass-through tax structure.
An S-Corp must adhere to certain requirements, as follows:
- It operates in the United States.
- It can have no more than 100 shareholders, limiting the company’s potential growth.
- Shareholders must be individuals, certain trusts, or estates; they cannot be business entities.
- It can only trade one class of stock.
LLC vs. S-Corp: The Similarities
Before we look at the differences between LLCs and S-Corps, there are several ways in which they are similar. Knowing this will help you understand the differences more easily.
1. They each offer limited liability protection.
This means, simply, that the owners of the business are not personally responsible for debts or liabilities incurred by the company. Instead of the onus being on the individual, it lies with the corporation.
Liability protection is not all-pervasive; as the name implies, it has limits. Owners or members are not protected if a state deems that activities on the part of the owners “pierce the corporate veil.” Basically, that means an individual has set up a company to perpetrate a fraud.
Different states have different regulations about what constitutes “piercing the corporate veil” – some are stricter than others.
Another case in which a business owner or member is not protected from liability is when he or she uses personal funds to establish the business, such as taking out a home equity loan to purchase business equipment.
A failure to separate the personal and business assets could also potentially result in diminished liability protection.
2. They are separate from the owner or members.
While LLCs and S-Corps are governed by different regulations, in both cases the business is separate from its owners or members, with its own assets, debts, federal identification number, and credit history.
3. Both LLCs and S-Corps are pass-through tax entities… most of the time.
An S-Corp, as defined by the tax code, is a pass-through tax entity. Although it was originally designed as a pass-through entity, members can choose to tax an LLC as a traditional corporation.
Being a pass-through tax entity means that the business neither files its own separate tax forms nor pays corporate taxes All profit or loss is passed on to the shareholders/members to be reported and settled on their individual tax returns.
4. State-mandated compliance rules.
States have their own set of statutes that govern the way LLCs and S-Corps are structured and run. Some of these regulations include: paying annual fees, filing periodic reports, appointing a registered agent, and informing the state of name changes or any other changes to the business, either within the formation state or when doing business as a foreign entity.
5. Both can take advantage of new tax benefits.
Thanks to the new Tax Cuts and Jobs Act (2017), both entities are now allowed a 20% deduction in qualified income from pass-through entities. This is a significant deduction for S-Corps shareholders and LLC members, respectively.
LLC vs. S-Corp: The Differences
The main difference between an LLC and an S-Corp is an LLC is a legal business entity, and an S-Corp is simply a designated tax status that must adhere to certain IRS requirements.
- An LLC is run by members, according to provisions set forth in its articles of organization. Members can elect to make decisions jointly and to divide their debt and assets however they see fit. This is called a member-managed LLC. An LLC can also opt for a more top-down organizational structure, in which one person manages those with subordinate roles and responsibilities. This is called a manager managed LLC.
- An S-Corp starts as a legal entity, either an LLC or a traditional C corporation, and then elects S-Corp treatment for taxation purposes. If the underlying legal entity is a C corporation, the business will have officers and be owned by the shareholders who have stock in the company. However, an S-Corporation can also function exactly like an LLC.
An LLC can choose to be taxed as a C corporation, but an S-Corp, by virtue of the tax code that governs it, must opt for pass-through taxation.
LLC Benefits and Advantages
An LLC is a great way for small businesses to minimize liability. In this sense, an LLC provides significant advantages over a sole proprietorship or a partnership.
Better than an Limited Liability Partnership
An LLC provides protection for all members of the company, from founding members down to regular payroll employees, while an LLP only protects the partners.
Flexible Business Structure with Minimum Oversight Requirements
By registering as a manager managed LLC, member can organize their business much like a standard corporation, but because LLC regulations are less strict than corporate regulations, they are not required to submit an annual report, reducing the level of oversight.
No Cap on Growth
S-Corps are restricted both in the number of shareholders they can have and the class of stock they can offer. There are no growth restrictions on LLCs.
S-Corp Benefits and Advantages
Being an S-Corporation comes with the following benefits.
You are fully protected from liability.
First off, all employees, officers, shareholders, and directors are fully protected from any liability. In case anything happens—whether that means mounting debt or a lawsuit against the company—all shareholders are protected.
There are diverse ways to obtain funding.
If the underlying legal entity for an S-Corp is a traditional corporation (a “C” corp), outside revenue can be generated through the sale of shares in the company, and it easier to gain outside financing.
You can avoid double-taxation.
This is another major advantage, particularly compared to C corporations. Taxes are pass-through, meaning that owners report profit and loss on their personal returns, which could potentially save your company a great deal of money over the long-term.
Additionally, taxes are paid only once a year, instead of quarterly.
At the end of the day, S-Corps are bound by certain regulations, and that limits them as a business structure.
Here are some of the specific reasons why.
You must be a citizen of the United States or at the very least a permanent, legal resident to incorporate an S-Corp. LLCs have no such restriction.
A Limited Number of Shareholders
As an S-Corp, you are limited to only 100 shareholders. For small businesses, this may not be an issue, but it may be a consideration if you intend to expand in the future.
Corporate fees and State Taxes
You must first set up a C corporation or LLC prior to becoming an S-Corp. There are fees and expenses associated with this process, some of which are ongoing, depending on the state of incorporation. Some states will require you to file an annual report and/or pay franchise tax fees.
In order to maintain your S-Corp status, you will be required to qualify on an ongoing basis. Any mistakes made with regard to filing requirements could result in the termination of your S-Corp status.
The Potential for Closer Scrutiny from the IRS
The risk of getting audited for having an S-Corp has actually declined in recent years. However, the people getting audits are mostly compliant. That means you run the risk of facing an audit just for choosing S-Corp treatment, not because the IRS has uncovered red flags.
To S-Corp or Not to S-Corp … That Is the Question
First, let’s review the basic requirements and process of electing S-Corp status for a traditional C corporation.
To be Eligible for S-Corp Status:
- You will need to have less than 100 shareholders.
- None of your shareholders can be corporations or partnerships.
- All your shareholders must be US citizens or legal residents of the United States.
- You must have only one class of stock.
If these requirements are met, you are ostensibly eligible for S-Corp treatment.. However, you should make sure you have a good financial advisor because if any of the mandatory reports or filings are not completed, you could risk losing your S-Corp status and would then be relegated to C corp status.
What You Need to Form an S-Corp
- Choose your business name, if such a process is required in your state.
- File your articles of incorporation.
- Issue stock certificates to your shareholders.
- Obtain the appropriate licenses and permits you need to operate within your industry.
- Apply for an employer identification number (EIN).
- Apply for any other tax identification numbers required by your state and/or local government offices. You will need these for your payroll tax remittance as well as workers compensation, unemployment insurance, and so on.
Within two and a half months of forming your corporation, file IRS form 2553.
The Main Advantage to Choose S-Corp Treatment for a Traditional C Corp: Avoiding Double Taxation
It works like this. When you have a C corporation, the business files its own income taxes and pays a standard corporate rate on profits. Any dividends that come to you and other shareholders, by virtue of your holdings in the company, however, are taxed again, and at your own personal marginal rate.
For a small company, where the owners are the primary shareholders, this can be a heavy tax burden.
The temptation is to pay yourself and other principals such a high salary that it reduces shareholder profits, thereby minimizing the higher tax rate. If the IRS finds out that you are trying to manipulate the company profits in this way, however, you may be in trouble.
When you elect S-Corp treatment for your corporation, you avoid this issue altogether because all the profits and losses pass through your personal income tax.
Whether this is advantageous to your and your company depends on many factors, including a need for capital investment in the business, the total amount of corporate profit, the percentage of shares you personally hold in the company, and a number of other factors.
Obtaining S-Corp Treatment for Your LLC: Yeah or Nay?
Thus far, the article has looked at the advantages of choosing S-Corp election for a traditional C corporation. It’s easier to see clear advantages (and potential drawbacks) here because the C corporation does not have pass through taxation.
But what about your LLC? Are there advantages to choosing S-Corp treatment for a legal entity that already has pass-through taxation?
The short answer is yes, there are advantages, even for very small LLCs. The main one has to do with your employment status.
When you choose to be taxed as an LLC, the owner is taxed like a partner, nor an employee. That means you have to pay taxes on all the profit at your regular marginal rate, including the self-employment taxes.
When you elect S-Corp treatment for your LLC, however, you can shelter some of that income from payroll tax by claiming it aS-Corporate profit rather than employee salary. That can potentially save you money.
The fact that you are both an owner and an employee when you choose S-Corp treatment for your LLC can also help you to maximize the 20 percent deduction available to pass-through entities under the Tax Cuts and Jobs Act of 2017.
The main drawback to choosing S-Corp treatment for an LLC, and the reason most small businesses don’t do it, is it is complicated and requires due diligence to remain compliant. Moreover, in some situations, the math simply does not work out in your favor.
Our ‘Help Me Choose Entity’ Tool Will Give the Best Answer.
As you can see, choosing to be taxed as an LLC or S-Corp can be difficult.
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