Looking to start a company but confused about the best options?
You aren’t alone. This is a common question.
You may have heard of an LLC and S-Corp before. They are two of the most common types of business structures when registering a 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.
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LLC stands for limited liability company. It is a legal entity that combines the tax benefits of a general partnership with the liability protection of a corporation. It is also one of the most common types of company, particularly for small businesses.
Some features of the LLC are as follows:
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:
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.
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.
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.
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.
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.
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.
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 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. Confused? We can help you.
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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.
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.
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.
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.
Being an S-Corporation comes with the following benefits.
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.
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.
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.
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.
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 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.
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:
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.
Within two and a half months of forming your corporation, file IRS form 2553.
If you don’t want to fill out any long paperwork like this, you can make this process much easier by using our business formation services.
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.
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.
As you can see, choosing to create as an LLC or S-Corp can be difficult.
To make it easier for you to decide which is best for you, we have created a free ‘help me choose entity‘ tool. It asks you some short questions and will tell you which type you should choose – in less than a few minutes.
LLC or S-Corp? Try Our Free Tool To Help You
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