LLC vs S Corp | The Ins and Outs to Help you Choose
If you're planning to start a company, you have to consider which type of entity structure is best suited to your business needs. Your company's legal structure can have an impact on what taxes you'll pay and what liability protection you will enjoy.
Several entrepreneurs decide on whether to establish an LLC or a corporation taxed as an S-corp.
As a Mergers and Acquisitions specialist, I worked with several entrepreneurs and helped them form their businesses. I'll share my insights regarding these two entities to help you make an informed decision.
Quick Summary
- An LLC is a form of a business entity, while an S corp is a tax designation.
- An LLC and a corporation with an S corp status both benefit from pass-through taxation.
- According to data from the IRS, around 60% of small businesses opt for an LLC structure, whereas 33% choose the S corporation status for their tax advantages.
- In my experience with the industry, I can attest that an LLC or an S corp is the best way to start a small business, since both entities offer tax benefits and personal liability protection.
At a Glance: LLC and S-Corporation
An LLC is a type of business entity that provides owners with personal liability protection, benefits from pass-through taxation, and has a flexible management structure.
An S corporation is an IRS tax designation that enables companies to avoid double taxation on corporate income.
According to data from the IRS, around 60% of small businesses opt for an LLC structure, whereas 33% choose the S corporation status for their tax advantages.
Key Differences
An LLC and an S Corp differ in terms of:
1. Taxation
Limited liability companies can be taxed as a pass-through entity or a corporation. A pass-through entity means that income taxes are not paid at the business level, members pay taxes only in their individual returns.
S corporations benefit from pass-through taxation in that corporate income is not subject to tax. Shareholders of S corporations report the flow-through of income, losses, deductions, and credits on their personal returns and are assessed and taxed at the individual level.
To avoid double taxation, I recommend that small companies designated as C corporations apply for an S corp status.
S (Subchapter S of the Internal Revenue Code) corporations differ from C (Subchapter C) corporations in that C corps are taxed on corporate earnings and individual profits or dividends.
"The primary distinction between S corporations and LLCs lies in their taxation structure. S corporations are taxed as pass-through entities, where profits and losses flow through to the shareholders' personal tax returns, whereas LLCs have the flexibility to opt for taxation as either a pass-through entity or a corporation."
- Jon Morgan, CEO, Co-Founder & Editor-in-Chief of Venture Smarter
2. Business Structure
Limited Liability Company
An LLC may be owned by an individual, a partnership, or by several entrepreneurs, referred to as members. Limited liability companies offer flexibility in business management since the members can appoint themselves as manager or employ a professional service to act as one in their behalf.
In terms of organization, LLCs are less structured since state laws do not require them to have a board of directors or conduct annual meetings. A limited liability company only has to submit annual reports and pay federal taxes in order to operate legally in the state.
S-Corporation
An S corp is similar to any corporation except for its tax status. It offers the same liability protection, ownership, and management structure as a C corporation.
As a corporation, an S corp must have a board of directors, draft corporate bylaws, conduct shareholders' meetings, and record minutes of the meetings.
To qualify for S corporation status, the corporation must meet certain requirements. It must be a domestic corporation that has no more than 100 allowable shareholders, and have only one class of stock [1]. According to the Internal Revenue Service, approximately 80% of eligible corporations opt for S status due to tax benefits and shareholder limitations.
Due to these limitations, S corps are ideal for small businesses since corporations, partnerships, and nonresident aliens cannot qualify as shareholders.
Before applying for the tax classification, I advise my clients to produce all the necessary documents and verify with the IRS if their company qualifies.
What Are The Advantages And Disadvantages Of An LLC?
Advantages
- Personal asset protection: Since the finances of the company are separate from the personal assets of the members, any legal action taken against the company will exempt the properties of the LLC owners from liability. I always emphasize the importance of opening a separate business bank account in order for clients to maintain personal asset protection.
- Pass-through taxation: The corporate earnings of an LLC are not subject to taxation, the profits are pass-through to the members and are taxed on their personal individual returns.
- Flexible management structure: The LLC may be collectively managed by the owners, a single-member, or ran by a company or individual not affiliated with the company.
The LLC as a separate entity means earnings are not subject to self-employment taxes, and the owner's personal assets are shielded from liability in case of a sue by third parties.
Disadvantages
- Transfer of ownership: All members must approve the transfer of ownership in an LLC, making the process more complicated when compared to a corporation.
- Limitation of existence: Once the purpose of the LLC has been met, or the members decide to venture in a different business, the company may be voluntarily dissolved.
What Are The Advantages And Disadvantages Of an S-Corp?
Advantages
- Pass-through taxation: An S Corporation is a business entity that benefits from pass-through taxation, the profits, losses, deductions, and credits of the company are passed through to the shareholders and taxed on their individual returns.
- Personal liability protection: Since an S corporation is regarded as a separate entity, the personal assets of the shareholders are protected from legal action. The only loss that shareholders may incur is the capital they invested in the company.
- Transfer of ownership: Shareholders can simply sell their stocks if they want to get their percentage share or leave the company. A business associate had the option to withdraw their shares and invest it to launch their own company.
Disadvantages
- Compliance rules: To qualify as an S corp, the company has to comply with state business laws, limit the number of shareholders, and meet eligibility requirements.
- Tax monitoring: An S corporation is closely monitored by the IRS to ensure that the company remains in compliance with their tax designation. The tax classification of an S corp may be revoked by the IRS anytime if any requirements are violated.
- Growth or expansion: Since an S corp is subject to regulation, there's less potential for the company to grow and expand.
FAQs
Can a Single-Member LLC Be an S Corp?
A single-member LLC can be an S corp if it meets the eligibility requirements of the IRS.
How Do I Make My LLC an S Corp?
To make your LLC an S corp, you must first file Form 2553 (Tax Election by a Small Business Corporation) with the Internal Revenue Service. The IRS will determine whether your business meets S-Corp qualifying requirements.
References:
- https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
