- An S Corporation isn't a business entity like an LLC; it's an elected tax status.
- LLC owners must pay self-employment tax (12.4% for Social Security; 2.9% for Medicare), while S-corp owners can pay less self-employment tax, provided the individual is paid a reasonable salary.
- LLCs can have an unlimited number of members, while S-corps are limited to 100 shareholders.
The business structure you choose dictates your path to commercial success, but choosing the right entity requires extensive research and personal reflection. Each structure has its own set of guidelines, benefits and drawbacks.
How do you know if you should set your business up as a limited liability company (LLC) or an S-corp? We spoke with accountants and business advisors to get their take.
What is the difference between an LLC and S-corp?
An S-corp is not a business entity like an LLC, sole proprietor, partnership or corporation. It's an elected method of determining how the business will be taxed. 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.
Establishing an LLC can protect you and your personal assets. With an LLC, the owner is not liable for any debts and obligations. If the LLC is sued by a debt collector, that debt collector can only go after the LLCs assets, not the owner's personal assets.
LLC members are not employees, so contributions to Social Security and Medicare are withheld from their paycheck. Instead, LLC members are required to pay self-employment taxes directly to the IRS. Self-employment income is taxed at a rate of 12.4% for Social Security and 2.9% for Medicare, according to the IRS. Any income generated by the LLC is considered taxable income, while income generated by an S-corp can be deducted as a business expense from the company's taxable income.
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. This includes subsidiary restrictions – LLCs are allowed subsidiaries without restriction, while S-corps aren't allowed to set up any subsidiaries.
LLCs cannot issue stock, while S-corps can issue stock, but only one class of stock. LLCs and S-corps also have varying differences in management and profit allocation, 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 offices who manage daily business operations.
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 more sense financially.
As income from the LLC increases, so, too, does self-employment tax, according to Vincenzo Villamena, CPA, managing partner of 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, but unless there is a specific reason to do so, it may not be the best move for a single-member LLC, according to Anthony Viola, CPA, and senior partner of 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' reasonable compensation regulations."
Viola says this means that FICA taxes would have to be paid on those wages, although they might not have to be paid on the full amount of taxable income before the owners' salaries.
What certificates are required for an LLC and S-corp?
To understand LLCs and S-corps, it helps to understand C-corps. Taxed under Subchapter C, C-corps are separately taxable statuses that file the Form 1120. An LLC or C-corp may be converted into an S-corp by filing the Form 2553 with the IRS, considering all Subchapter S guidelines are met.
LLCs require business owners to file with the state the LLC was formed in, and these requirements may vary depending on the 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 desire to incorporate. An annual shareholder's meeting and additional state reporting is also required.
Should I have my LLC taxed as an S-corp?
While the structure you choose for your business depends on you, the owner (or owners), and business, there are some benefits ‒ and drawbacks ‒ to be aware of if you have your LLC taxed as an S-corp.
- There's limited liability. You can choose to pay self-employment taxes on your salary from the business rather than on the business's gross income.
- You are allowed up to 100 shareholders.
- There are additional earnings that could be treated as unearned income, thus being tax-free.
- There's a salary cap. You must establish reasonable compensation for owner-employees.
- You're limited to one class of stock.
- Members who own more than 2% of the company's stock can't claim employee health insurance as a tax-free benefit.
Having your LLC taxed as an S-corp once you hit the $60,000 per 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 per year mark is usually where that plays out. Before then, it's best to accept the money as personal income and file the Form 1040 on your personal return.
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, according to business owner Micah D. Wright.
"Shares or stock represent a shareholder's interest in a corporation, even if the corporation decides not to issue stock certificates and merely keeps track of the number of shares allocated on paper," Wright said. "An LLC that wanted to hold an ownership interest in an S-corp purchases shares, not a 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.
Ideally, business owners and entrepreneurs would set their new ventures up as an LLC to have some legal protection for their personal assets. Once the business grows, it's a good idea to investigate filing as an S-corp because of the financial benefits. Determining how many investors, stock classes and foreign owners will be members of your LLC should be considered in order to follow the proper guidelines, according to your state laws.