Choosing the right business type is important to the success of your business. Find out whether your company should be an LLC or S corporation.
- An S corporation isn't a business entity like an LLC; it's an elected tax status.
- LLC owners must pay self-employment taxes for all income. S-corp owners may pay less on this tax, provided they pay themselves a "reasonable salary."
- LLCs can have an unlimited number of members, while S-corps are limited to 100 shareholders.
- This article is for entrepreneurs who are trying to decide whether they should structure their business as an LLC or S corporation.
When starting a business, you have several types of business entities to choose from. LLCs and S corporations are popular options, but they differ in many ways, from taxes to management structure. In some instances, a business may even be both an LLC and an S-corp. Here's what you need to know about these business types and their differences before you decide which is right for your business.
What is an LLC?
An LLC, which stands for "limited liability company," is a business structure that protects the personal assets of the business's owners (referred to as "members"). If the business gets tangled in legal troubles or is sued by a debt collector, the plaintiff or creditor can only go after the business's assets, not the personal assets of the LLC members.
If the LLC is taxed as a sole proprietorship, it has the tax advantages of being a pass-through entity, which means its profits "pass through" the business to the LLC members, so they can report the profits on their personal tax returns rather than filing a corporate tax return. The LLC members must pay self-employment tax on their income.
Alternatively, an LLC may be taxed as an S-corp, which means the member must be paid a reasonable salary, which the LLC reports as a business expense and deducts payroll taxes from. The business's remaining profits are distributed as dividends.
Key takeaway: An LLC shields the personal assets of the members from business creditors. It is a pass-through entity, so LLC members report earnings on their personal tax returns.
What is an S-corp?
An S corporation, also referred to as an S-corp or S subchapter, is a tax election that lets the IRS know your business needs to be taxed as a partnership. It also prevents your business from incurring corporate-level double taxation. To become an S-corp, your business first must register as a C corporation or LLC.
In an S-corp, the business owners are called shareholders. As an owner, you are considered an employee of the business and must pay yourself a reasonable salary. An S-corp's profits, losses, deductions and credits are taxed at the shareholder level.
To qualify as an S-corp, your business can have one to 100 shareholders. Your business must also be located in the U.S., and you must file with the IRS as an American corporation.
Key takeaway: An S corporation is not a type of business – it is a type of tax election. The tax liability of S-corp sole proprietorships or partnerships belongs to the members, or shareholders. An LLC may also file as an S-corp.
What is the difference between an LLC and S-corp?
Small business owners often choose to structure as an LLC because it offers more freedom than corporation structures. But before making this critical decision, it's important to know the differences between the LLC and S-corp.
An S-corp is not a business entity like an LLC, sole proprietorship, partnership or corporation. Rather, it's an elected method of determining the way your business will be taxed. With an S-corp tax status, a business avoids double taxation, which is when a corporation is taxed on its profits and then again on the dividends that shareholders receive as their personal earnings.
An LLC can be an S-corp – or even a C corporation – depending on how the business owner chooses to be taxed. An LLC is a matter of state law, while an S-corp is a matter of federal tax law.
In an LLC, members must pay self-employment taxes, which are Social Security and Medicare taxes, directly to the IRS. These tax rates change on an annual basis, but the self-employment income tax rate in 2020 is 12.4% for Social Security and 2.9% for Medicare, according to the IRS. Any income an LLC generates is considered taxable income.
With an S-corp, shareholders are paid a salary and the business pays their payroll taxes, which can be deducted as a business expense from the company's taxable income. If the business has leftover profits, they are distributed to shareholders as dividends – which have a lower tax rate than regular income.
LLCs and S-corps also differ in management, according to Guy Baker, Ph.D., founder of Wealth Teams Alliance.
"When members manage an LLC, the LLC is much like a partnership, or a sole proprietorship if there's only one member," said Baker. "If run by managers, the LLC more closely resembles a corporation, as members will not be involved in the daily business decisions."
Baker stated that S-corps generally have directors and officers; a board of directors oversees corporate formalities and major decisions. The directors elect officers who manage daily business operations.
Shareholder structure, subsidiary restrictions and stock
S-corps can't have more than 100 shareholders total, while an LLC can have an unlimited number of members. Additionally, S-corps can't have non-U.S. citizens as shareholders, but an LLC allows non-U.S. citizens to be members.
They also have different subsidiary restrictions. LLCs are allowed subsidiaries without restriction, while S-corps aren't allowed to set up any subsidiaries.
Finally, LLCs cannot issue stock, while S-corps can – though they can only issue one class of stock.
Key takeaway: Choosing the right entity requires extensive research on how the guidelines and restrictions will affect your business taxes, management structure, and ability to form subsidiaries and issue stock.
Is an LLC or S-corp better for entrepreneurs?
Honestly, it depends. Filing to become an LLC is a good approach to begin with, because this structure offers liability protection and tax write-offs. However, as your business grows beyond the startup stage, switching to an S-corp may make financial sense. As income from the LLC increases, so does the self-employment tax, according to Vincenzo Villamena, CPA and managing partner at Global Expat Advisors.
"With an LLC, the income passes through to the owner, who has to pay 15.3% self-employment tax," Villamena said. "If the owner resides abroad, the Foreign Earned Income Exclusion can minimize income tax but not self-employment tax. With an S corporation, on the other hand, the owner can take a salary from the profits and apply the Foreign Earned Income Exclusion to minimize income tax."
S-corps may make more sense financially for many businesses, but unless there is a specific reason to make the switch, it may not be the best move for a single-member LLC, according to Anthony Viola, CPA and senior partner at KVLSM LLP.
"I personally like the flexibility that LLCs offer business owners," Viola said. "Yes, there's the downside of having to pay self-employment taxes, but in an S-corp, the owners are required to take salaries under the IRS's reasonable compensation regulations."
Key takeaway: Whether your business should be an LLC or an S-corp depends on the stage it's in. LLCs typically work best for startups, but as your company grows, you may want to become an S-corp to reduce self-employment taxes.
What certificates are required for an LLC and an S-corp?
To understand LLCs and S-corps, it helps to understand C corporations. Taxed under Subchapter C, C-corps are separate taxable entities that file Form 1120. An LLC or C-corp may be converted into an S-corp by filing the Form 2553 with the IRS, as long as it meets all Subchapter S guidelines.
LLCs require business owners to file with the state the LLC was formed in, and these requirements may vary by state, according to Brian Cairns, CEO of ProStrategix Consulting.
"Most states require some public notification, which can be costly depending on the jurisdiction," Cairns said. "For example, in New York state, you have to advertise in the county in which the LLC is formed. If you form in one of the five boroughs of NYC, this can cost upward of $1,000."
For S-corps, you'll need to file articles of incorporation in the state where you want to incorporate. An annual shareholder's meeting and additional state reporting are also required.
Key takeaway: To be taxed as an S-corp, you must fill out Form 2553, file articles of incorporation in your desired state and meet Subchapter S guidelines. LLC requirements vary by state and may require public notification.
Should I have my LLC taxed as an S-corp?
While the right structure for your business depends on you, any other owners, and the business itself, you should be aware of both the benefits and the drawbacks if you have your LLC taxed as an S-corp.
- The business pays your salary and the payroll taxes on it. This may save you money on taxes because, as with a regular LLC, you would pay self-employment taxes on the business's gross income.
- Additional earnings are distributed to shareholders as dividends. This may also save you money, since dividends are taxed at a lower rate than income.
- There's a salary cap. You must establish reasonable compensation for owner-employees.
- You're limited to one class of stock and 100 shareholders.
- Shareholders own more than 2% of the company's stock and can't claim employee health insurance as a tax-free benefit as they could with a C-corp.
Having your LLC taxed as an S-corp once you hit the $60,000-a-year mark is a great decision, according to Scott Royal Smith, founder and CEO of Royal Legal Solutions.
"This allows you to divide the income between personal income and dividend income, and gets you to a lower overall tax rate," Smith said. "The drawback is that you also have to pay for an individual S corporation tax return at that point. You have to weigh the tax savings in what you're keeping from the government against how much the CPA is going to charge you."
Smith believes that the $60,000 annual mark is usually where that plays out. Before then, it's best to accept the money as personal income and file Form 1040 on your personal return.
Key takeaway: Having your LLC taxed as an S corporation can save you money on self-employment taxes. However, you will have to file an individual S-corp tax return, which means paying your CPA to file an additional form. An S-corp is also less structurally flexible than an LLC.
Can an LLC purchase membership interests in an S-corp?
Generally, no, but there are loopholes in business and finance. The ownership stake of an LLC member is called a membership interest, and owners of an S-corp are called shareholders.
Shares or stock represent a shareholder's interest in a corporation. In the event the corporation does not issue stock certificates and only documents the number of shares distributed on paper, an LLC that wants ownership interest in an S-corp would purchases shares, not membership interest.
An LLC with more than one member can't purchase or own S-corp stock because it violates Subchapter S guidelines. However, a single-member LLC that's taxed as a disregarded entity could own S-corp stock, which is uncommon.
Key takeaway: Although a single-member LLC or a business deemed a disregarded entity can own stock in an S-corp, an LLC with more than one member cannot purchase membership interests under Subchapter S guidelines.
Many entrepreneurs set up their new ventures as LLCs to have some legal protection for their personal assets. When your business grows, though, it's a good idea to speak with your CPA and look into filing as an S-corp for the financial benefits. You should also determine how many investors, stock classes and foreign owners will be members of your LLC in order to follow the proper guidelines under your state laws.
Joshua Stowers contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.