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As you look into what type of business entity to form for your dream business, you’ll hear options like “Limited Liability Company” and “Corporation.” Many business owners start out by forming a limited liability company, or LLC. But some small businesses find it preferable to operate as an S corp. Which one is the better choice for you? To decide, you need to understand the difference between an LLC and S corp.

Both LLCs and S corporations (S corps) are great choices depending on what you want out of your company. Both offer asset protection by separating your personal assets from your business assets, something you won’t get if you run your business as a sole proprietor. And with both, profits pass through to the owners, which avoids the double taxation of regular corporations.

But the differences are significant between an S corporation vs LLC. There are pros and cons to each that you should know about before choosing one over the other.

Here are eight things to consider before you decide between forming an S-Corp vs LLC:

What is the difference between an LLC vs S Corp?

An LLC is a type of business entity that gives the business a separate legal existence from its owners. By contrast, an S corp isn’t a separate business entity. It’s a tax classification that can be adopted by LLCs or traditional corporations. It’s a desirable option for many limited liability company members because it can potentially save some LLC owners a lot of money in self-employment taxes.

LLCs are usually treated as pass-through entities for tax purposes. All the profits and losses passes through to the owners, who are called members. The members pay self-employment taxes (Social Security and Medicare taxes) and income tax on all of the profits.

S Corps are considered accounting entities. They calculate income and expenses at the corporate level and then allocate profits to individual shareholders. That difference is what can potentially save owners a significant amount on Social Security and Medicare in an S corp vs an LLC. Here’s how it works.

Potential Self-Employment Savings for S corp owners

Owners can potentially pay less in Social Security and Medicare in an S corporation vs an LLC. Owners who work in the S corp must be paid a salary. Like any employee, they pay half of the Security and Medicare taxes due on their salaries. The business pays the other half. The salary and the employer’s portion of Social Security and Medicare are tax deductible expenses to the S corporation.

If there are profits after all the salary and other expenses are accounted for, the profits pass through to the earners. For S-corp owners, those pass-through profits are subject only to income tax, not self-employment tax.

In addition to having the business pay half of their employment taxes, owners may be able to save more on Social Security and Medicare by choosing to pay part of their earnings as salary and part as profits. Keep reading for more information on how this works.

LLCs and corporations both have the option to be S corps, as long as they meet certain criteria.

First, let’s dive into what each of these terms means.

What is an LLC?

As explained above, an LLC is a legal business entity intended to provide limited liability protection to the owners (who are called members in an LLC). Creating a separate legal entity with an LLC or corporation usually protects the personal assets of the owners from those making a claim against the company.

Benefits of a separate legal entity

In other words, if someone sues the business or the business goes into debt, they’re usually limited to making claims against the company’s assets, and the personal assets of the owners (for example, their personal bank account, house, kid’s college fund, etc.) are off-limits.

It used to be that the only way for a business owner to get this kind of liability protection was to incorporate, but this wasn’t ideal for everyone. So, LLCs are a relatively new form of business. Although the first LLC law went into effect in Wyoming in 1977, the IRS didn’t officially recognize limited liability companies until 1988, and it wasn’t until 1996 that all 50 states recognized them.

LLCs and Taxation

For starters, corporations have to deal with “double taxation.” When a C corporation makes a profit, it’s taxed on the profits. Then, when the profits are distributed to the individual owners (“shareholders”), the profits are taxed again. Hence, double taxation.

LLC members, though, can avoid this double taxation. A typical LLC isn’t taxed on the business profits. Instead, all the profits are distributed to the individual members. The members report those profits and pay income taxes and self-employment taxes on them on their individual tax returns. Thus, the profits are only taxed once. This is known as “pass-through” taxation.

LLC members also have the option to be taxed as a corporation, which we’ll get into later when we talk about S corps.

Operational differences between an LLC and S corp

The other major benefit provided by the LLC business entity is formality, or rather the lack thereof. By law, corporations must appoint a board of directors, hold annual shareholder meetings, keep extensive records, and generally adhere to more regulations. They’re also limited in how they can be organized and managed. LLCs have much more freedom.

As long as all the members agree, they can manage the LLC how they want, which includes dividing up ownership and profits in the way they prefer. They just have to put it all in writing in an operating agreement

What is an S Corp?

As we mentioned, an S corp is a tax classification, one that both LLCs and C corporations (the most common form of corporation) can apply for. The “S” refers to Subchapter S of the Internal Revenue Code.

The S corporation tax classification can have advantages for both corporations and LLCs. For corporations, it’s usually a way for them to avoid double taxation because it allows them to be taxed like a pass-through entity. LLCs already have pass-through taxation by default, but they can usually save the members a lot of money in self-employment taxes by filing as an S corp. More on that later.

S Corp Filing Requirements

Not every corporation or LLC can qualify for S corporation status, though. They must meet the following requirements, which include having:

  • Only U.S. shareholders (or members for an LLC), which can be individuals, certain trusts, and estates
  • No shareholders/members that are partnerships, corporations, or non-resident aliens
  • No more than 100 shareholders/members
  • Only one class of stock

An LLC or corporation needs to complete Form 2553 with the IRS to apply for S corp status.

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What are the benefits of an LLC?

So, what are the advantages and disadvantages of LLC vs. S corp?

S corps and LLCs that haven’t elected S corp status share the benefit of pass-through taxation. But non-S corp LLCs benefit because they don’t have to adhere to those regulations governing shareholders and classes of stock.

For instance, an LLC that has not chosen to be treated as an S corp can have more than 100 members and can have members who live outside the U.S. or are corporations. There are also no stock classification restrictions.

An LLC that doesn’t apply for S corp status has less paperwork to file with the IRS, too. They don’t have to file Form 2553 or Form 8832 to be taxed as an S corporation.

LLCs without S corp status also have less-complicated taxes. An S corp LLC will have the added step of filing Form 1120S, U.S. Income Tax Return for an S Corporation, at tax time. And, generally speaking, the S corp status invites more scrutiny (read: audits) from the IRS than a standard LLC.

Because of this additional scrutiny, S corps may want to do many of the same formalities that C corporations have (such as regular meetings and extensive record keeping) even if they’re not legally required to. It can come in handy in an audit.

What are the benefits of an S Corp?

For an LLC, adopting S corp status could mean saving a lot of money in taxes. Here’s how:

In an LLC that’s operating as a sole proprietorship or partnership, members are not employees. For tax purposes, they are self-employed. They don’t get paid a salary. Instead, they take a draw against profits. The draw on profits is not a tax-deductible expense to the LLC.

In addition to income taxes, the members pay self-employment taxes (about 15.3%) on all profits they receive. This is more than the taxes they’d pay when working for someone else because employers pay half the Social Security and Medicare tax.

By electing S corp status, though, members who work for the business become employees of the LLC, and as such, are paid a salary. However, they may choose to take part of their earnings from the business as profit and part as salary.

Once they do that, they only pay the employee’s half of employment taxes (Social Security, Medicare) on the amount of salary they are paid. When remaining business profits (income minus all expenses including salaries) are passed through to them, they don’t have to pay Social Security and Medicare taxes on the profits. They just have to pay income taxes.   

Thus, if a single-member LLC operating as an S corporation was making $150,000 a year, they might choose to split up their earnings and take $100,000 in salary and $50,000 in profits. The $100,000 salary would be subject to Social Security, Medicare, and FUTA (in addition to regular income taxes). The $50,000 in profits would be subject to income taxes but not self-employment tax. Thus, they’d save about $7,650 in self-employment taxes.

However (remember the scrutiny we mentioned earlier?), the IRS expects you to pay yourself at least a “reasonable” salary (as in, something on par with what others in your field are making) so that you’ll still pay something in self-employment taxes and contribute to Social Security and Medicare. So, if you’re thinking of paying yourself an annual salary of $2 to avoid taxes, think again.

Are S corp earnings subject to self-employment tax?

Owners of an S corp are not considered self-employed, so they can pay themselves a salary from the company. They’ll pay employment taxes on that salary, but not the remaining profits. This can mean substantial savings and is one of the benefits for an LLC filing as an S corp.

When should your company become an S corp?

That will depend on your business’s circumstances (again, a tax professional can help here). As far as the time of year to file, if you’re a new business, you must file Form 2553 no more than 2 months and 15 days after the beginning of the tax year the S corp election is to take effect. If you have an established business, you could file at any time during the tax year preceding the tax year it is to take effect. The IRS has more details on the instructions for Form 2553.

Is an S corp an LLC?

An S corp is a tax classification, while an LLC is a legal business entity. LLCs and corporations can both apply to be S corps.

What is pass-through taxation?

Pass-through taxation occurs with business entities like sole proprietorships, partnerships, and LLCs, where the profits for the business are only taxed once, when they’re distributed to the individual members. This is as opposed to double taxation, in which the business itself is taxed on the profits before they’re distributed to the individuals owners, where they’re taxed a second time.

Can a single-member LLC be an S corp?

Yes. Only having one owner of the LLC doesn’t disqualify it from filing to be an S corp.

How can we help?

Now that you understand the basics of the benefits of an S corp vs. an LLC (without an S corp status), you’ll have to weigh all the factors to see which choice best fits you and your business. We don’t recommend doing this alone, though. It’s times like these when you need a skilled tax professional to help you make a decision.

If you’re planning to start an LLC, with or without the S corp designation, we can handle the process for you. Our LLC formation service sets you up with experts who can file the paperwork with the state for you. And, if you’d like to form your LLC as an S corp, our S corporation service can take care of that added step, too. Once you’re established, we have other services like Worry-Free Compliance to help you stay compliant with government regulations.

You can do this. We can help.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

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