What is best for your business?
The type of business entity and tax structure affects your organization’s financing and compliance requirements. Two common options are limited liability companies (LLCs) and S-corps.
Although the arrangements share characteristics, there are clear differences between them. Notably, an LLC can choose S-corp classification for tax purposes. Therefore, it is essential to compare LLC vs. S-corp options when forming your business or reaching a certain level of profitability.
We evaluated S-corps versus LLCs by examining regulatory provisions, tax methods, and costs. Our guide outlines the benefits and drawbacks of each option. In addition, we provide recommendations for choosing between the two.
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What is a limited liability company?
Advantages of an LLC
- Provides personal asset protection.
- An unlimited number of LLC members, including non-U.S. citizens.
- Flexible tax and administrative options.
Disadvantages of LLC
- You must pay self-employment taxes.
- LLC dissolution requirements vary by state.
- LLCs do not pay salaries to the owners or members.
A limited liability company (LLC) is a state business structure, which means the rules vary depending on the state in which you form the entity. Most states allow unlimited LLC owners, referred to as members. Corporations, individuals, foreign entities, or other limited liability companies can have single or multi-member entities.
Many entrepreneurs choose an LLC over a sole proprietorship because the entity type protects personal assets, such as your home. This can reduce your liability if someone files a lawsuit against your business or when you file for bankruptcy. However, most insurance companies and banks cannot use the LLC structure.
As a pass-through entity, LLC members pay self-employment taxes (Medicare and Social Security taxes) and income taxes on their personal tax returns. This approach simplifies taxes but can have a downside once an individual reaches a certain tax bracket. Because LLC members don’t pay themselves a salary, they can’t take advantage of some of the health insurance and 401(k) tax benefits.
However, members decide whether the IRS will view the LLC as a disregarded entity, partnership, or corporation for tax purposes. This flexibility means you can change your status to reduce your tax burden later.
Although LLCs require fewer formalities than corporations, problems may arise if an LLC member dies or the owners wish to dissolve the LLC.
What is an S corporation?
S corporation pros
- It may reduce the tax burdens of self-employment.
- Personal liability protection.
- Businesses can contribute to retirement and insurance plans.
Disadvantages of S Corporation
- Not all businesses or owners qualify for S-corp status.
- Only 100 shareholders are allowed.
- Additional federal and state tax requirements.
A subchapter S corporation, known as an S-corp, is a tax election, not a business entity type. LLCs and C corporations can choose this tax method if they meet IRS federal eligibility requirements. An S-corp can have one owner called a shareholder or up to 100 owners.
Contributors are limited to individuals and certain trusts or estates. Shareholders cannot be non-resident aliens, corporations or partnerships. This can be beneficial for small business owners who want to limit ownership. However, a fast-growing company may prefer the flexibility of LLCs and LLCs, as both allow an unlimited number of members.
S-corps retain the personal liability protection afforded to LLCs. Likewise, the IRS views S-corps as pass-through entities. This designation means that shareholders report income and deductions on their personal tax returns. An S-corporation does not pay federal income taxes but must file an annual form with the IRS.
Corporate officers and shareholders who provide anything more than simple services should receive reasonable compensation. Therefore, shareholders can also be employees. The IRS classifies the salaries of shareholders and employees as Federal Insurance Contributions Act (FICA) wages, the Federal Unemployment Tax Act (FUTA) and for income tax purposes.
The tax advantages of operating as an S-corp are two-fold. First, an individual only pays employment taxes on wages, not non-wage distributions. Business owners can reduce their tax burdens by paying themselves reasonable salaries and taking a percentage of profits as a distribution.
Second, the company can contribute to the employee’s (or employer’s) retirement plan and help with insurance premiums. Eligible payments are not subject to FICA taxes and may be counted as a deduction when calculating corporate profits and losses.
However, S-corps may require more paperwork, and choosing the right strategy is more complicated when considering an S-corp rather than an LLC.
What do an LLC and an S-corp have in common?
Before deciding on an LLC or S corporation, consider how similar the structures are. Use this information to evaluate the pros and cons of both approaches.
S-corps and LLCs share the following characteristics:
- Liability protection: Both structures limit personal liability, meaning that only creditors or plaintiffs can access business assets. They usually cannot go after your residence or personal vehicle.
- IRS eligibility limits: Not all companies can qualify as S-corps or LLCs. Federal tax regulations restrict insurance companies and some financial companies from operating as limited liability companies, or S-corps.
- Pass-through taxes: Both entities can show business profits and losses on personal tax returns, with individual members or shareholders claiming the tax burden.
- State obligations: Individual state laws determine reporting, fees, and registered agent requirements for LLCs and S-corps. States also set foreign entity rules for companies doing business within state borders.
- Trade credit: Unlike a sole proprietorship, LLCs and S-corps separate personal and business liabilities. This section can facilitate the establishment of business credit.
What are the main differences between an LLC and an S-corp?
When comparing LLC versus S-corp entities, there are far more contrasts than similarities. For starters, corporations form LLCs through the US state(s) in which they do business, while an S corporation is a tax election governed by the Internal Revenue Code (IRC).
Other differences between S-corps and LLCs include:
- Ownership restrictions: Most states allow LLCs to have an unlimited number of members, while the IRS allows no more than 100 shareholders in an S-corp. Various domestic and foreign entities can be members of an LLC, but S-corp shareholders cannot be non-residents or non-U.S. corporations.
- Management options: Owners can run the LLC like a partnership and control day-to-day operations or choose a managing member to operate like a corporation. Multi-person S-corps have a board of directors to oversee business affairs and elect officers to manage day-to-day operations.
- Annual requirements: States typically require less information on an LLC’s annual report than on an S-corp statement. In addition, companies must hold board meetings and record their minutes. While experts recommend that LLCs hold annual meetings, it is not a requirement.
- Distribution of profits and losses: S-corps distribute profits and losses according to their ownership percentage. Although this is also the default method for LLCs, members can choose different customizations by documenting them in the operating agreement.
- Salaries: LLC business owners do not receive a salary. Instead, they take the owner’s lottery. S corporations pay wages to any shareholders (including owners) who provide services.
- Federal taxes: The IRS treats LLCs as pass-through entities by default, but an entity can choose to file as an S-corp or C-corp. An S-corp is also a disregarded entity, but it cannot file as a C corporation unless it is an incorporated structure.
What is best for your business?
The legal and tax implications can differ significantly between LLCs and S-corps. Discuss your options with your financial and tax advisors when comparing the advantages and disadvantages of an LLC versus an S-corp.
When should you choose an LLC?
The best LLC services make it easy for startups and small businesses to set up an LLC. However, there are other reasons to form an LLC.
Circumstances in which an LLC may be the best option include:
- When your company’s profits are equal to or close to the reasonable salary of others in your profession.
- If one or more of your current or potential business owners are not US citizens.
- When your company wants to move away from default profit and loss distribution methods.
- Sole business owners and freelancers who prefer simple federal and state tax, payroll, and reporting requirements.
- Organizations considering bringing in a foreign investor, corporation or limited liability company as a stakeholder.
When should you choose an S-corp?
After forming an LLC or incorporating your business, you can choose to be taxed as an S-corp. Business owners, shareholders or members can take advantage of this tax status.
An S-corp may be the best choice under the following circumstances:
- When you determine that it is possible to reduce your self-employment tax burden by receiving a reasonable salary and earnings.
- If owner-employees can benefit from company contributions to retirement or health insurance plans.
- A company considering attracting outside institutional investors may have better results as an S-corp.
- Your company is registered as a C corporation but meets the requirements to file as an S corporation.
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