LLC vs. S Corp (Which is right for me?)
When starting a business, one of the most important decisions you will make is choosing the right legal structure. The most common options for small businesses are Limited Liability Companies (LLCs) and S Corporations (S Corps).
Both LLC and S Corp offer at least limited liability protection and pass-through taxation, but there are significant differences between the two that can affect your business’s operations, taxes, and growth potential. In this article, we’ll explore the key differences between LLCs and S Corps, so you can make an informed decision on which legal structure is right for your business.
There is no one business structure that is better than the other, but some will fit better for certain businesses. To make the right decision for your new business, it is important to read through and understand the intricacies of each business structure, its advantages, and disadvantages.
But we know that entrepreneurs are short on time, so here is the shortest version of the answer: the majority of small businesses will benefit most from an LLC. This structure offers legal protection and a simple startup process without a heavy tax burden. Unless you need to issue shares or you want the business to be a separate legal entity, an LLC will get the job done. You can also convert it to an S corp at a later date.
LLC vs. S Corp
It is important to first understand that an S corp is not the same as a C corp, which is usually just called a corporation – we will cover that soon! In some ways, it is an in-between option for a C corporation and an LLC, and you will need to decide where your business falls on that spectrum. Keep reading to understand the basics of each structure and its pros and cons.
LLC stands for Limited Liability Company, and it is just that: a company that limits the owner or owners’ liability. In something like a sole proprietorship, there is no legal separation between owner and business – if the business owes a debt, is sued, or goes bankrupt, the owner is implicated, and their personal assets can be seized. An LLC ensures that personal assets are not at stake, offering important protection.
You may see an LLC termed as a single-member LLC, meaning it has only one owner, or a multi-member LLC if it has multiple owners. The process to form the LLC is typically very simple in either case, involving filing an Articles of Organization with the Secretary of State and assigning a registered agent. Depending on state law, there may be small fees to pay or annual reports to keep up with, but no other requirements.
One unique element of LLCs is their tax status. While the business is a separate legal entity and can be taxed as a corporation, it can also lead to eligibility for pass-through taxation. This allows the owner or owners to claim business income and expenses on their personal tax returns, circumventing the corporate tax rate and often saving money.
Best for: An LLC is a great choice for anyone that values flexibility and simplicity in terms of administrative tasks, while still wanting to protect their assets. If your business deals with many clients and large sums of money, but does not need to issue shares of stock or use a Board of Directors, LLC is likely the best fit.
Advantages of an LLC
LLCs are a popular choice for business owners because they can offer the best of two worlds – the legal protection of a larger business and the tax status of a smaller one. With financial, legal, and tax benefits, there are many reasons to choose an LLC.
- Credibility: Including “LLC” or something similar in your name lets potential customers know that you are a trustworthy entity and have properly registered your business. It may even help you obtain business loans and other funding.
- Asset protection: The owners of an LLC are protected against debts, lawsuits, and other obligations of the business. Personal assets are not seized or used to pay these, which makes LLC a safer option for many.
- Pass-through taxation: LLCs are afforded a lot of flexibility with taxes. While they can choose to be taxed as a corporation, most will engage in pass-through taxation which allows the owner to claim company profits and losses on their personal income taxes, avoiding double taxation and leading to large tax savings.
LLCs are also very simple to form, with most states not even requiring an operating agreement, so they can be a fast way to become a formal business.
Disadvantages of an LLC
While they are popular, LLCs are not the right fit for every business venture. There are some pitfalls to the corporate structure that you will want to understand before committing.
- No stock options: An LLC cannot sell stocks in the company, which means it cannot acquire shareholders. This may make it more difficult to raise capital as a startup or to grow to a larger size.
- Self-employment taxes: The owner of an LLC is considered to be self-employed by the IRS (Internal Revenue Service) and must pay special self-employment taxes to cover things like Medicare taxes and Social Security. In some cases, this can cost more than the typical withholding of payroll taxes in an S corp.
- Asset protection: In some ways, an S corp goes further in offering protection because it is a completely independent legal entity from the owner. An LLC’s protection has some limits in place.
An S corp (short for subchapter S corporation) is a subset of the broader business structure of a corporation and shares many of its qualities, like management structure and record-keeping requirements. But a corporation can be given the tax classification of an S corp if it meets certain requirements, which allow for pass-through taxation.
To start an S corp, you will first need to form a traditional corporation (or C corporation) and then apply for this tax status. The status will only be granted if the corporation meets the following requirements:
- No shareholders that are not a U.S. citizen or resident.
- The number of shareholders cannot be greater than 100.
- All shareholders must be an individual or a specially allowed trust or estate.
- Cannot be owned by another corporation.
- May only issue one class of stock.
For businesses that meet these requirements, an S corp can be a great fit. The entity type allows for pass-through taxation, which avoids high corporate tax rates, while still giving the maximum amount of asset protection.
Best for: Businesses that want to act as a corporation without paying the same taxes may be well suited for an S corp. There are strict requirements, so any business that meets them and still wants to be a corporation may be a good fit.
Advantages of an S Corp
- Pass-through entity: An S corp is primarily chosen for the option to utilize pass-through entity status. Rather than pay federal income taxes at the corporate level, each shareholder pays taxes on their own share of the business profits and distributions, which is usually less expensive. The business itself is not subject to corporate income tax, though it still pays employment taxes.
- Lower self-employment tax: In an LLC, the owner is considered self-employed and must pay the corresponding taxes. An S corp allows owners to be considered an employee, so you can choose to only pay Medicare and Social Security taxes on your income.
- Asset protection: An S corp offers the full protection of a corporation, so there is very little chance your personal assets would ever be at risk.
- Flexibility: Unlike LLCs, an S corp exists in perpetuity regardless of the death or departure of an owner. This makes it easy to change owners over time and transfer shares.
Disadvantages of an S Corp
Along with the many advantages of an S corp, there are legitimate reasons it may not be the right structure for your business.
- Corporate formalities: Corporations require more paperwork than just an Articles of Incorporation. To maintain a corporation, there are stringent requirements to follow. This includes annual tax returns, quarterly federal returns for employees, and detailed record-keeping and bylaws. Along with the time these forms take, they often include fees to file forms.
- Restrictions in stock: S corps have less flexibility than C corps when it comes to how many shareholders there can be, who can be a shareholder and the classes of stock that can be issued.
- IRS scrutiny: Because of the strict requirements, S corps are often under close watch from the IRS, which looks for things like reasonable salary and adherence to guidelines.
LLC vs. S Corp – Final word
With an understanding of both LLCs and S corps as business entities, you should be more equipped to decide the right option for you. An LLC is typically sufficient for most small businesses, but S corps offer a bridge to corporation status without all of the complexity.
Whichever you pursue, it is important to follow all of your state guidelines and maintain your status over the years.
Are S corps and LLCs the same for tax purposes?
When it comes to personal income taxes, both S corps and LLCs are pass-through entities. Owners and shareholders can claim a profit on their personal taxes. However, other taxes are different: for example, an LLC owner will pay self-employment tax, while an S corp shareholder will take normal withholdings.
Can I change from an LLC to an S corp?
You can choose to have your LLC taxed as an S corporation by filing the appropriate forms after forming an LLC. This will give it the tax classification of an S corp, but not the same privileges as a C corp, so long as it meets the requirements.
What makes a business eligible for S corp status?
In order to be an S corp, a business must already be formed as another type of business. It must then meet the following requirements: under 100 shareholders, no shareholders that are not U.S. citizens or residents, only one class of stock, and shareholders must be individuals or trusts.