Last Updated on July 19, 2023 by Ewen Finser
Do you wish to take your sole proprietorship to the next level? Are you worried about your personal assets being tied to your business and wish to get protection from its liabilities? Or do you want to open up a new business and cannot settle on a suitable legal structure?
The law outlines a couple of business structures that anyone can explore, but their differences and similarities can overlap and make it hard for you to pick a suitable one. In this, we will breakdown two common ones – LLC and S Corp and explain what they are to help you choose the best one for your business.
LLC vs S Corp – 3 Main Differences
The Main Differences Between an LLC and S Corp are:
- An LLC is a business legal structure, whereas an S Corp is a tax election status allowed on LLCs and Corporations to specify how they will want the entity taxed.
- An LLC has unlimited shareholders, whereas an S Corp limits the number to 100 shareholders
- An LLC is taxed twice, i.e., at the corporate level and from the dividends, whereas an S Corp is taxed once
What is an LLC?
A Limited Liability Company is a business structure in the United States where the owners are not liable for the company’s debts. It is a hybrid structure that borrows the characteristics of a sole proprietorship or partnership and a corporation.
If you need an entity that will cushion your personal assets from liabilities, then an LLC is the easiest way to go. It borrows the limited liability features of a corporation and the tax benefits of a partnership. It can be formed for profit and nonprofit purposes.
The laws governing LLCs are under state regulations. They vary from state to state, and it is prudent to find out the ones that apply to you before forming one. The owners are called members, and most states do not restrict the form they can take. A member can be an individual, corporation, or even another LLC.
An LLC is a more formal entity that requires one to file articles of organization with the state. They can elect not to pay federal taxes and have the profits and losses listed on the owner’s personal returns. Alternatively, they can choose to be taxed as a corporation, and here is where the concept of the S Corp comes into play.
What is an S Corp?
An S Corporation or S subchapter is not a legal business structure. It is a tax election status that informs the IRS to tax the business in a certain way. Usually, one has to choose between an S Corp and C corp in terms of how they will be taxed, and their differences will be highlighted below.
An S Corp gives a Corporation with less than 100 shareholders the benefit of incorporation while still being taxed as a partnership. This is meant to avoid double taxation as the corporation passes income directly to the shareholders.
Before we look at the details of what an S Corp is, we should explain what a corporation is. This is a legal entity that is entirely independent of its owners. It is often referred to as a “legal person.” It can enter into contracts, borrow money, sue, hire employees, and pay taxes just like a normal person.
You will find the term corporation explained differently across the world, but its main feature is limited liability. One of the caveats of a corporation is double taxation, and here is how an S Corp helps out.
S Corps are not only limited to corporations as LLCs can also gain this status. In an S corp, the owners are called shareholders, and the law sees you as an employee of the company. You have to pay shareholders a reasonable salary as the profits, losses, credits, and deductions are taxed at the shareholder stage. They report income and losses on their individual tax returns and pay taxes at regular rates.
Note that the tax burden of an S Corp, partnerships, and sole proprietorships fall with the owners or shareholders.
Another tax election status opposite to the S Corp is the C Corp. Read on and find out what it is to understand the distinction.
What is a C Corp?
We’ve mentioned LLC vs S Corp, but what about a C corp? A C Corporation is a tax election status where the owners are taxed differently from the entity. These entities are eligible for corporate income taxation, which results in a double taxation scenario.
Here, the entity pays corporate taxes on the amount earned before distributing the rest to shareholders. While this might seem like a disadvantage, it comes with the benefit that the company can reinvest profits in the company at a lower corporate tax rate.
How Do You Form an LLC?
The laws surrounding LLCs vary from state to state, but the ones around the formation of an LLC are not any different from those listed below.
1. Find the Members
Here, you need to establish who owns the LLC. It could be one or several individuals, a business, trust, or foreign owners. Note that foreign owners will be subject to special tax requirements by the government. Certain entities, such as banks and insurance companies, cannot own LLCs.
2. Choose a Name
While this rule might vary, the general principle is that the name of your LLC should not be the same as another business in that state. Most states also prohibit the use of specific terms in the title. You can browse the state’s website to find the business names that are already registered. If you settle on a name, states allow you to reserve it for some time as you complete all the other processes.
3. Pick a Registered Agent
This is an entity that receives official documents on behalf of the LLC. All states have their requirements for registered agents, and several companies offer these services.
4. Get an Employer ID
You will need to get a Federal tax number (EIN) even if you are not planning to hire any employees. This number will allow you to open a bank account, sign contracts, and obtain various documents. You can complete the application online or by phone with your state.
5. Form an Operating Agreement
This document specifies how the business will run, the responsibilities of the members, and how to distribute returns across the owners. All states have mandatory clauses that should be included in the Operating Agreement and confirm that you have all these covered.
6. Register the LLC
The first step to registering an LLC is by filing the Article of Organization with the secretary of state. All states require different things to register an LLC successfully and check with the ones that apply to you so that you do not miss out on anything. In some states, you will have to file a certificate of formation to register the new LLC.
7. File a Notice
A few states require that you file a short notice on the local newspapers announcing your intention to form an LLC. It must be published several times over many weeks.
8. Register for State Taxes
You have to account for the income you get from the minute the LLC is formed. This way, ensure that you register from both income and sales tax with your state from the word go.
How to Form an S Corp?
An S Corp is a tax election and not a business structure. This way, you will need to have an LLC or Corporation in place before choosing your preferred tax structure. For a corporation, the applicable requirements, such as choosing a name, drafting the articles of incorporation and registering the corporation with the secretary of state, preparing corporate bylaws, selecting directors, and issuing stock to the shareholders, will precede. Once the corporation is up and running, you will be in a better position to form the S Corp.
Note that your business has to meet specific requirements for it to qualify for the S Corp status. To be eligible, it has to;
- Have one class of stock
- Have no more than 100 shareholders
- Have individuals, certain trusts, estates, and specific organizations as shareholders
Once you meet these criteria, you will have to file an S Corporation election with the IRS on IRS Form 2553. It should be signed by all shareholders and filled in a timely fashion. The time required to process an S Corp election request depends on whether the business has been operating for some time or in its first tax year.
New businesses must file for an S Corp election not later than two months and 15 days after starting their first tax year. Filing after this period won’t hold, and the status will apply in the second tax year.
For businesses that have operated in previous tax years, they must file for this status by the 15th day of the third month of the current year.
What is the Fine Line Between an LLC vs S Corp?
Impact on Tax
This is perhaps the main difference between these two. An S Corp is not a legal structure, but a tax implication, but it has differences in how a regular LLC is taxed. With the S Corp status, your business steers clear of double taxation. This implies that they won’t have their profits and dividends paid to shareholders taxed. Note that LLCs have the free will to get an S Corp tax status since it is a matter of federal tax law.
With an S Corp, shareholders earn a salary, and their business pays their payroll taxes, which can be deducted from the overall income.
For an LLC, members have to pay self-employment and other applicable taxes to the IRS. These rates change every year, depending on the prevailing economic forces. Every cent an LLC generates is considered taxable income.
An LLC can have an unlimited number of shareholders, while S Corps are limited to 100. Additionally, S Corps only allow members to be residents of the United States, whereas an LLC can have foreign shareholders. LLCs are permitted to form subsidiaries with no restrictions while S Corps are not allowed to create any. Finally, LLCs can issue stock and S corps, but only a specific class of stock.
The Good and Bad of LLC vs S Corp
Pros of LLCs
- Limited liability
- Flexibility with the management
- Can be managed by managers or members
- Easy to split financial interests
- Simple to form and run
Cons of LLCs
- They are taxed twice
- Lack of legal restrictions makes them unappealing to investors
Pros of S Corps
- Easier to obtain additional funding from investors
- Members can receive both salary and dividends
- Easy to form one once all the requirements are met
Cons of S Corps
- Restrictions on management and structure
- Allocation of financial interests hard since it has to be proportional to ownership
- Limit to the number of shareholders
Frequently Asked Questions
Which is better for taxes, LLC or S Corp?
While it all depends on your organization, an S Corp tax election status is hugely beneficial to a company. This is because it avoids double taxation where the company is taxed at the corporate level, and the members are also taxed on their dividends.
Should I make my LLC an S Corp?
If you wish to avoid the double taxation on LLCs, then making it an S Corp would be the most sensible thing to do. However, you need to go through the restrictions that apply to S Corps and ascertain that you won’t have a problem with them.
Can a single-member LLC be an S Corp?
Yes. An SMLLC (Single Member Limited Liability Company can elect to have the business taxed as an S Corp successfully.
LLC vs S Corp – Bottomline
Both an LLC and S Corp have their pros and cons. If you are looking to form a business, and still find it hard to pick between the two, understand that they might be suitable for different scenarios. An LLC is the simpler of the two and will work if you need a lot of flexibility in running the business.
It also sounds useful if you want to allocate profits based on other criteria other than percentage ownership. A good example is if one member actively participates in running the business and thus deserves a more significant share.
Alternatively, you might lean towards an LLC if you want to avoid the requirements imposed on S Corp and do not think that pass through taxation affects your business.
An S Corp is suitable if you want earnings to be distributed proportionally, earn a salary from the organization, and find it easy to attract investors. There are more restrictions to forming one, but it is a more structured entity that appeals to the public than an LLC.