S corp vs LLC

The S corp vs LLC choice is massively significant for most small businesses looking for the best structure for tax and liability.

Some focus on the limitation of the maximum number of members as a determining factor. Sure, an S corp is limited to 100 members. But after all, most entities belonging to either of these two types are small or medium enterprises.

On a different note, both LLCs and S corps aren’t subject to double taxation. This means that you get to keep the same profit for the same part of your net income with both structures, right? Well, not exactly.

An LLC requires you to pay self-employment tax as high as 15.3%, while an S corp allows you to take out a dividend. But is this difference worth the complex filing process?

Let’s find out!

What Is an S Corporation?

The S corporation (colloquially referred to as S corp) is a business structure that allows for taxation under Subchapter S of Chapter 1 of the IRS (Internal Revenue Service). The key thing here is that, unlike C corporations, S corps don’t pay income taxes. Instead, income is divided among shareholders, and each of them pays individual income tax. This is the so-called pass-through entity, which is a model that allows businesses to avoid double taxation.

Since it’s a legal entity with limited liability and pass-through taxation, this structure is, in some ways, similar to an LLC. This naturally leads to comparisons of all sorts.

Benefits of an S corp

S corps have several advantages that serve as the main culprit for choosing this business structure.

S corporation ownership:

The owners of an S corp are referred to as shareholders. One thing that separates the S corp from its C corp counterpart is the fact that it cannot have more than 100 shareholders. The ranks of these shareholders are limited to:

  • Individuals
  • Non-profits
  • Trusts
  • Estates

What this means is that institutional investors are not allowed. Also, since there is only one type of share class, all shareholders are equal.

S corporation taxes:

The most significant advantage of S corporations is the pass-through taxation. This means that any income gain or loss is passed through (hence the name) directly to the shareholders. From here, they must report the amount on their personal income tax returns.

This is great for startups because it allows for the tax-free accumulation of passive income. However, if the corporation does that without registering as an S corporation, it risks being classified as a personal holding company.

Keep in mind that the corporate tax rate varies by state, which is also something you need to consider.

S corporation transfer of ownership:

When making an S corp vs. LLC comparison, it’s essential to understand the difference between members and shareholders.

Shareholders in C corporations own a part of the company, but they don’t necessarily have a say in the way it’s run. In an LLC, on the other hand, every member has a vote. Similarly, since S corps only have one type of share class, every single shareholder has equal rights. This makes the transfer of equity more complex. Future owners may have a different management approach and ambitions, and with their voting rights, they can influence the future course of the business.

What are the Disadvantages of an S corp?

When it comes to registering as an S corp, the list of restrictions, rules, and requirements is quite elaborate.

  • Registering an S corp can be fairly difficult since you need to file Articles of Incorporation for every single state where you plan to operate.
  • You will also need a registered agent for each state. This downside, nonetheless, can be overcome by using a registered agent service.
  • When forming an S corporation, all your shareholders need to be US residents.
  • To qualify as an S corp, you also need to have only one class of stock. This isn’t necessarily a big problem but can be quite restricting when maintaining the internal organization in check.
  • The corporation can have a maximum of 100 shareholders.
  • Most importantly, all of your shareholders need to meet eligibility requirements (depending on the state).

With all of this in mind, it’s clear that these aren’t disadvantages in a traditional sense. Instead, the Subchapter S corporation is a business entity that simply has many bureaucratic restrictions.

What Is an LLC?

LLC is a business entity that provides legal liability protection similar to the one of a corporation. The difference is that the LLC is easier to register and incorporate.

Like S corps, LLCс are pass-through entities, which allows them to avoid double taxation. But the LLC owners are called members, and unlike with S corps (where the maximum is 100 shareholders), their number is not limited.

Advantages of LLC

The S corp vs LLC comparison is pretty common since both structures have a pass-through taxation status. Also, the majority of S corps start out as LLCs. Understanding the primary advantages of LLCs will help you decide whether you should even consider proceeding to the next stage.

LLC legal liability protection:

Registering an LLC is the simplest way to separate your own assets from that of your company. This way, members’ personal belongings (their homes, vehicles, equity in other enterprises) are protected from any potential prosecutions.

LLC taxation:

As far as the pass-through taxation is concerned, an LLC is taxed as an S corp. Members and shareholders get their part of the profit and need to submit this on their personal tax return sheet.

LLC ownership:

You can run an S corporation with one shareholder. Likewise, you can own an LLC even if you’re the only member. As far as the IRS is concerned, you will not be treated any differently than a sole proprietorship would. However, in terms of legal liability, there’s a massive difference.

What are the downsides of LLC?

There are several downsides of the LLC structure that you should also be aware of when choosing whether to go with an LLC or an s corp.

  • First of all, registering an LLC may require quite a bit of paperwork (depending on the state). This is why some members opt for assistance from LLC services.
  • LLCs have an annual fee that depends on the state. For instance, in California, this annual cost goes up to $800. Needless to say, this fee needs to be paid in every state in which your LLC is doing business.
  • Gaining outside investment is difficult because you can’t sell shares of your company. This limits your options of leveraging the equity in order to raise capital.

In other words, LLC is a simple solution for those who want paperwork that is as simple as possible while still getting legal liability protection.

What Is the Difference Between an LLC and an S Corp?

The most effective way to make this comparison is to take some of the most relevant factors and look at them side by side. So check this s corp vs LLC chart out!

LLC S Corp
Personal liability Members are typically not held liable Shareholders are typically not held liable
Management Members are free to set up their desired structure Shareholders elect directors
Taxation Pass-through Pass-through
Number of shareholders/members Unlimited Maximum 100
Self-employment tax Yes No
Status Legal entity Tax status

To further clarify the matter, let’s discuss each difference between an LLC and an S corp:

Personal liability

Under the S corporation structure, the personal assets of shareholders are protected from debts of the enterprise. However, the same thing goes with the LLC. So this shouldn’t be a major factor when facing the LLC or S corp dilemma.

The path towards this liability protection is a different matter. It goes without saying that it’s a lot easier to register an LLC than an S corp. This means that if you’re looking for the quickest way to get incorporated and get basic legal liability, LLC is the way to go. Still, you can’t become an S corp without first being an LLC or a C corp.

Other than this, it’s also worth mentioning that it is far more likely that in your state, it’s legal for an S corp to own an LLC than the other way round.

Management

The question of management is huge when it comes to the LLC vs S corp choice. Here, an LLC gives a lot more flexibility.

As an S corp, you will have to elect a board of directors and officers. Other than this, you’ll also have to hold an annual meeting, submit an annual report, and so on.

On the other hand, there are no such requirements for LLCs. The thing is that you can put all of the structural and management issues into an operating agreement. You can also appoint one of the members to be a member-manager or look for an outside manager.

Taxation

Subchapter S ensures that S corps pay only one level of tax rather than double taxation. In a way, this is a tax structure suitable for those who want to run a corporation but still pay the taxes as if they were an LLC.

There are several requirements that a corporation needs to fulfill in order to qualify for an S corp status.

These are:

  • It needs to have less than 100 shareholders.
  • All of these shareholders need to be persons. In some rare cases, LLCs may qualify as owners, but not banks or insurance companies.
  • The corporation can only have one class of stock.
  • All shareholders need to be US residents.

The fact that an LLC has no such requirements tips the S corp vs LLC scale slightly in favor of the latter. In other words, even though S corporation taxes seem more favorable, they might be unavailable.

Number of shareholders/members

The number of S corp members is limited to 100, which is a requirement that an LLC simply doesn’t have. An LLC can have as many members as you like. Now, all LLC members have a vote during meetings, which wouldn’t necessarily be the case in a C corp. However, since an S corp cannot have more than one share class, shareholders have a similar status to members in an LLC.

On paper, the difference between an LLC and an S corporation in this field may not seem that great because both LLCs and S corps usually belong to the small/medium enterprise category.

Moreover, the reason for this seemingly unnecessary limitation is the fact that the S corporation structure is primarily aimed at family-owned and other small businesses. In other words, this limitation exists so that massive corporations cannot abuse the pass-through taxation of the S corp tax structure. It makes sense, doesn’t it?

So, this really needs to be examined from the S corp vs C corp vs LLC perspective, instead of comparing just the S corp/LLC pair.

Self-employment tax

The biggest potential downside of LLCs is the self-employment tax, which can be as high as 15.3%. This is a significant chunk of your profit, which is why the LLC structure is only a good idea if your profit is similar or lower than what your income would be if you were to have traditional employment.

For anything above this, the S corp seems like a more frugal solution. Among the advantages of an S corporation, this one seems to be one of the biggest.

On the other hand, there are some scenarios in which an LLC is clearly a better option. For instance, LLCs that hold rental properties aren’t subject to self-employment tax because they produce passive income.

Status

This is one of the most controversial points in this comparison, mostly because S corps and LLCs technically don’t belong to the same category. In theory, the LLC and S corp structures don’t necessarily have to be mutually exclusive.

Namely, an S corp is a tax status (tax designation). This is why you can’t register as an S corporation straight away. Instead, you need to start as either an LLC or a C corp and then apply for an S corporation status.

Pros and Cons of S Corp

So, which is better, an LLC or an S corp?

Sometimes, it’s easier to make a choice if you have all the pros and cons listed briefly in one place. So, here you go:

The biggest perks of running an S corp business are:

  • No double taxation
  • No self-employed tax
  • Limited liability protection
  • Straightforward transfer of ownership

The most notable downsides of S corp status are:

  • One class of stock
  • Limited to 100 shareholders
  • Depending on your specific requirements, the results of your LLC versus S corp consideration may have a clear winner.

Pros and Cons of LLC

The fact that an LLC is so easy to register (compared to qualifying for S corp) is already a huge advantage. Here are some other consideration points.

The greatest advantages of running an LLC are:

  • Flexibility of management
  • Limited liability protection
  • No double taxation
  • Simple registration process

And the disadvantages of choosing the LLC structure are:

  • Annual maintenance cost
  • Problems with raising capital

All in all, LLC is an old and proven business structure with a long list of perks and downsides that you can work with.

Should I Form an LLC or an S Corp?

Because you can’t go with an S corp right away, starting out as LLC is probably your safest choice. Then, you need to take into consideration your current situation. If you meet all the criteria for an S corp, you should probably apply.

Generally speaking, if your profit is similar to what you would make as a manager, there’s not much reason for you to switch from an LLC.

However, as an S corp, you don’t pay taxes on the dividend, which could save you a significant amount of money.

So, this just might be worth the extra paperwork.

FAQ

Is LLC a corporation?

An LLC is a legal entity that provides members (owners) with liability protection similar to that of a corporation. The simplest and the most accurate way to explain LLC would be to say that it’s a structure that combines the best of both the corporate and sole proprietorship business types.

How do I pay myself from my LLC?

The concept of taking money out of your LLC is called an owner’s draw. If you’re a single-member LLC, you can just write yourself a check or transfer the funds via your LLC’s accounts. On the other hand, if you’re running an LLC with other members, you need to take an active part in its operations to pay yourself a salary. In the eyes of the IRS, you will be seen as self-employed.

Is an S corp a business entity?

Unlike LLCs or C corporations, an S corp is not a business entity — it is a tax status.

Can an S corp be a member of an LLC?

In some states, an S corp can be a member of an LLC. The exceptions are professional limited liability companies (PLLC). The other way round (LLC owning an S corporation) is usually not an option.

Am I personally liable for the debt of S corporation?

Both S corp and LLC structures can help protect you from business debt. This means that if your entity starts losing money, your home, personal vehicles, or other assets wouldn’t be at risk. This isn’t the case with sole proprietorships or general partnerships.

Do S corp owners have to take a salary?

S corp owners don’t take a salary in a traditional sense. Instead, they get dividends. This is a part of the corporation’s profits (or reserves) paid to the shareholders (usually on an annual basis).

What can an S corp write off?

Shareholders of an S corporation can write off their losses against their individual taxable income. Tax deductions are much easier with the S corp tax structure, which is a strong case in any S corp vs LLC comparison.

ABOUT AUTHOR

Content writer and amateur boxer. A few years ago, I dived into the financial world with an aim to help both heavyweight and lightweight investors make a knockout. I love to spend my free time watching movies and playing video games. Other than this, doing the best I can to support my kid in achieving his lifelong dream of becoming a Ninja Turtle.

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